“Subchapter S” allows a traditional corporation meeting strict requirements to escape “double taxation” by making a federal income tax “election” to be taxed as a “pass-through” entity. As such, the “S” corporation form of business organization is not a different form of corporation at all, but instead strictly a creature of tax treatment.
The “S” Corporation is also incorporated by filing its Articles of Incorporation with the Office of the Secretary of State and applying for a Federal Employer Identification Number and state tax identification number. Then, the Corporation must, within roughly 2.5 months of the start of its tax year, “elect” to be an “S” Corporation by filing federal Form 2553, Election by a Small Business Corporation. An “election” filed after this point will not be effective until the start of the next tax year. Moreover, the Corporation will be considered a “C” Corporation for each tax year in which it makes no election or an invalid one. For each tax year with a valid election, the “S” Corporation is required to file a federal “S” Corporation return (Form 1120S). The Shareholders include their share of the “S” Corporation’s separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss on their federal individual income tax returns.
The main advantage of the “S” Corporation is its tax treatment. As stated above, the “S” Corporation is a pass-through tax entity – the income or loss generated by the business is reflected on the personal income tax returns of its owners. A qualifying corporation can avoid “double taxation” (that is, profits taxed first at the corporate level as income and again at the shareholder level when distributed as dividends) by electing to be treated as an “S” Corporation. Generally, an “S” Corporation is exempt from federal income tax other than tax on certain capital gains and passive income, allowing profits and losses to flow through to the Shareholders. In other words, the Corporation itself is not taxed on its income, and instead Shareholders pay tax on their proportionate share of such income. The “Subchapter S” election does not affect the status of the organization under state corporation laws as it is strictly a creature of federal income tax law.
Unlike the traditional corporation, the IRS narrowly restricts the ownership make-up of an “S” Corporation. The restrictions are designed to limit the availability of this favorable tax treatment, more or less, to small business enterprises. The restrictions are as follows:
1. The number of Shareholders cannot exceed 100;
2. All Shareholders must be residents of the United States;
3. The Corporation cannot be owned by other S Corporations or most business trusts, LLCs or partnerships;
4. The Corporation must have only one class of stock;
5. The Corporation generally may not own more than 80 percent of any other corporation; and
6. The Corporation must make a timely “election.”
D. Comparative Advantages of the LLC and the S Corp.
The LLC form of business organization may be superior to the S Corporation because, while both forms can be treated as “pass-through” entities for federal income tax purposes (i.e., the income or loss generated by the business is reflected on the personal income tax return of the owners), the IRS does not impose strict restrictions on its existence. That is, the IRS does not limit the number of Members the LLC can have, and its Members can be corporations, partnerships or non-residents. The LLC is free to issue more than one class of stock, so it can reward founders with common stock and grant only preferred stock to investors, etc. Furthermore, the LLC may own subsidiaries without restriction. Finally, the LLC state statutes do not require this form of business organization to follow strict corporate formalities common to corporations, such as holding regular meetings of the Board of Directors and at least annual meetings of the Directors and Shareholders.
On the other hand, the ownership interests in the S Corporation may be more readily transferred to third parties than can the membership interests of the LLC. Typically, the LLC restricts the transfer of membership interests without the approval of at least a majority of the interests. Typically, a shareholder of a corporation is not required to get approval of the other shareholders before selling stock.