Subchapter S Corporation

An S corporation has the same formal organization as a C corporation, but the income flows directly to the owners, who are taxed at their personal rate. Thus, the owners avoid the potential double taxation of a C corporation, yet they retain the advantage of limited liability.

Incorporating an S corporation includes the same procedures and filings as a C corporation. The owners must elect Subchapter S status with the IRS by filing Form 2553, Election by a Small Business Corporation, and they must meet certain criteria.

All of these criteria must be met in order to qualify as an S corporation:

• domestic corporation: organized under the laws of the United States, a state or a territory;
• shareholders: cannot be a nonresident alien; cannot be a partnership or a corporation and must meet additional similar measures;
• number of shareholders: cannot be more than 75;
• stock: can only be one class of common stock with no preferred stock; and
• certain types of corporations: are not allowed, such as an insurance company or a domestic international sales corporation.

Can I convert a C corporation to an S corporation?

Yes, if certain of rules are followed:

• All shareholders must agree to the election.
• No more than 25 percent of the company's gross receipts during the 3 prior years may be considered passive income (such as rent from a real estate investment).

Can I convert to a Subchapter S corporation whenever I choose?

Timing is important in becoming a Subchapter S corporation. If you want to convert from a C to an S corporation immediately after starting the business, you must file with the IRS within the first 2½ months of the company's first taxable year. If you do not meet the deadline, your business will be taxed as a C corporation.

If your business has been ongoing for some time as a C corporation, you can still elect Subchapter S status if you file with the IRS during the 12 months before the tax year that you want the company's status to change.

Tax Aspects of an S Corporation

Since an S corporation is treated like a partnership for tax purposes, each shareholder's portion of the profit or loss is included on his or her federal and state tax returns. This means that profits from the S corporation are only taxed once at the individual's personal tax rate. Shareholders are personally responsible for any related taxes and for estimated income taxes.

So profit and loss are allocated among shareholders just the way it is done for a partnership?

For an S corporation, profits and losses are allotted in the same proportion as the stock ownership. If someone owns 10 percent of the stock, their share of the profit or loss is 10 percent. This might differ from the allocation of a partnership, as a partnership agreement can specify a distribution of the profit or loss that might be different that the proportion of stock ownership.

Shareholder Liability

Other than its distinctive tax treatment, an S corporation has the same features as a C corporation. That is, beyond his or her investment in the business, a shareholder is not personally at risk for debts or other liabilities of the business.

Can I convert an S corporation back to a C corporation?

Yes, if the conditions for an S corporation are no longer being met.

Can an S corporation have ownership of a C corporation?

An S corporation can own 80 percent or more of a C corporation. It can also hold subsidiaries if it meets certain qualifications.