Subchapter S corporation definition
/What is a Subchapter S Corporation?
A Subchapter S corporation is a form of corporate organization under which the obligation to pay income taxes is passed through to the shareholders of the organization. The "Subchapter S" term comes from the segment of the United States Internal Revenue Code (Chapter 1, Subchapter S) in which the rules governing the formation and operation of Subchapter S corporations is located.
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S Corporation Requirements
The Subchapter S type of organization is only allowed if an organization has 100 or fewer shareholders, is a domestic corporation (i.e., not foreign), only has one class of common stock, and only has certain types of eligible shareholders.
Advantages of an S Corporation
There are several advantages associated with the S Corporation legal structure, which are as follows:
Taxed as a partnership. An S corporation is taxed as a partnership, which eliminates the double taxation associated with a shareholder dividend from which a normal corporation suffers, where the company is taxed on its income, and then its shareholders are taxed on their receipt of dividend income from the company. Instead, all earnings of the business are passed through to and recognized by the owners on their individual tax returns.
Liability protection. The shareholders in an S corporation are protected from any liabilities incurred by the corporation. In effect, the corporation acts as a shield, so that creditors of the corporation cannot access the assets of the shareholders.
Simple conversion from C corporation. You can switch from a C corporation to an S corporation quite easily, just by filing a form with the IRS.
Disadvantages of an S Corporation
A downside of the Subchapter S format is that the shareholders reporting the corporation's income on their tax returns must pay income taxes on those amounts, even if they have not received a distribution from the company. This means there can be considerable pressure for the company to regularly distribute cash to its shareholders, which may interfere with the formation of capital needed to grow the business. Thus, the S corporation structure may not work well for a business that requires a large investment in fixed assets and working capital.
Financial Reporting for an S Corporation
Because of the tax pass-through status of this type of organization, the business does not report an income tax expense on its income statement, nor does it report an income tax liability on its balance sheet.
Terms Similar to Subchapter S Corporation
A Subchapter S corporation is also known as an S corporation or an S corp.