The term “Subchapter S Corporation” (or S Corp) refers to a specific tax status designation by the IRS, not a distinct type of company. Businesses with 75 or fewer shareholders can apply for S Corp status, which allows them to be taxed similarly to partnerships or sole proprietorships. Typically, application for S Corp status occurs soon after incorporation. A company can revoke this status by filing a form with the IRS before the start of a new tax year.
Eligibility for S Corporation Status
To qualify for S Corp status, a business must meet certain IRS requirements:
* The company must have no more than 75 shareholders, all of whom must consent to the S Corp election.
* All shareholders must be U.S. residents or citizens.
* The company must have only one class of stock.
* The company must use a calendar year as its fiscal year.
Corporations meeting these criteria can file Form 2553 with the IRS to request S Corp status.
Advantages of S Corporation Status
S Corp status offers several benefits. The primary advantage is that income passes directly to the shareholders, who then report it on their individual income tax returns. This avoids double taxation, where the corporation’s income is taxed first at the corporate level and again when distributed to shareholders. In most cases, S corporations do not pay corporate income tax, and losses are absorbed by the shareholders.
Additional advantages include:
* Return on investment earnings are not subject to self-employment tax, provided the shareholder/employee receives reasonable compensation for their work.
* Financial documentation and accounting are less complex than those required for traditional C corporations.
* S Corp status can provide easier access to credit, depending on the corporation’s business history.
Disadvantages of S Corporation Status
Companies should also consider the potential drawbacks of S Corp status. Because financial power rests with the shareholders, major decisions require unanimous agreement. Disagreements can hinder progress. Additionally, shareholder/employees owning more than 2% of the stock must treat health insurance and other employee benefits as taxable income. S Corp status is generally most suitable for corporations with a small number of shareholders who share a common vision for the company’s future.