From William Perez,
Your Guide to Tax Planning: U.S..
FREE Newsletter. Sign Up Now!

Definition of a Subchapter S Corporation

An "S-Corporation" is a regular corporation that has between 1 and 100 shareholders and that passes-through net income or losses to shareholders under in accordance with Internal Revenue Code, Chapter 1, Subchapter S. Corporations must meet specific eligibility criteria, and they must notify the IRS of their choice to be taxed as an S-Corporation within a certain period of time.

Taxation of Regular Corporations

A regular corporation, sometimes called a "C" Corporation (after Subchapter C of the Internal Revenue Code), is taxed as a separate business entity. Corporations have their own tax form (1120) and their own tax rates (C Corp tax rates). Corporations may choose to retain their profits and earnings as part of their operating capital, or they may choose to distribute some or all of their profits and earnings as dividends paid to shareholders.

Dividends paid to shareholders are essentially taxed twice. They are taxed once at the corporate level (on the corporation's Form 1120), and again at the individual level (on the person's Form 1040).

Taxation of S-Corporations

An S-Corporation is not subject to corporate tax rates. "Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income," according to the Internal Revenue Service.

Instead, an S-Corporation passes-through profit (or net losses) to shareholders. The business profits are taxed at individual tax rates on each shareholder's Form 1040. The pass-through (sometimes called flow-through) nature of the income means that the corporation's profits are only taxed once – at the shareholder level. The IRS explains it this way: "On their tax returns, the S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of nonseparately stated income or loss."

S-Corporations therefore avoid the so-called "double taxation" of dividends.

S-Corporations, like regular C Corporations, can decide to retain their net profits as operating capital. However, all profits are considered as-if they were distributed to shareholders. Thus an S-Corporation shareholder might be taxed on income they never received. (Whereas a shareholder of C-corporation is taxed on dividends only when those dividends are actually paid out.)

Eligibility Criteria for S-Corporations

A corporation may choose to be taxed as an S-Corporation if it meets the following criteria.

1. The company is (a) a domestic corporation, or (b) a domestic entity eligible to elect to be treated as a corporation that timely files Form 2553 and meets all the other tests listed below. If Form 2553 is not timely filed, see Rev. Proc. 2004-48, 2004-32 I.R.B. 172.
2. The company has no more than 100 shareholders. (A husband and wife and their estates are treated as one shareholder for this test. A member of a family can choose to treat all members of the family as one shareholder for this test. All other persons are treated as separate shareholders.)
3. The only shareholders are individuals, estates, certain exempt organizations, or certain trusts.
4. The company has no nonresident alien shareholders. (That is, the only shareholders are US citizens and resident aliens.)
5. The company has only one class of stock. Generally, a corporation is treated as having only one class of stock if all outstanding shares of the corporation's stock confer identical rights to distribution and liquidation proceeds.
6. It is not one of the following ineligible corporations:
   • A bank or thrift institution that uses the reserve method of accounting for bad debts under section 585.
   • An insurance company subject to tax under subchapter L of the Code.
   • A corporation that has elected to be treated as a possessions corporation under section 936.
   • A domestic international sales corporation (DISC) or former DISC.
7. It has or will adopt or change to one of the following tax years.
   • A tax year ending December 31.
   • A natural business year.
   • An ownership tax year.
   • A tax year elected under section 444.
   • A 52-53-week tax year ending with reference to a year listed above.
   • Any other tax year (including a 52-53-week tax year) for which the corporation establishes a business purpose.
8. Each shareholder consents to the S-Corporation election.

Additional Information

Forming an S-Corporation and Electing S-Corporation Status
S Corporation Taxation
Accounting for S-Corporation Capital, Income, and Expenses
Preparing IRS Form 1120S
Issuing IRS Schedule K-1 to Shareholders
Preparing IRS Form 1040 Schedule E for S-Corporation Shareholders
Self-Employment & Payroll Taxes for S-Corporation Shareholders
Tax Tips & Audit Strategies for S-Corporation Shareholders