Is it a corporation? Is it a partnership? No, it’s an S corporation!!! Almost 60 years after it became part of the law, the S corporation is still the most common type of corporation in the United States today. But what exactly is an S corporation?
Well, the S corporation is a product of a different time — specifically, 1958. At the time, there were two basic ways to run a business: through a corporation, which had limited liability but whose earnings were subject to federal income taxation at both the entity level and the shareholder level (thereby giving rise to the potential for double taxation); or through a sole proprietorship or general partnership, which didn’t have limited liability but also weren’t subject to entity-level taxation. Lawmakers were understandably concerned that the benefits of being subject to only one level of tax were causing small businesses to forgo the security that comes from limited liability (Note that this was long before the advent of the limited liability company, which first became a thing in the United States in the late-1970s, let alone the IRS “Check-the-Box” regulations that came out in the mid-1990s and allowed unincorporated business entities to choose whether to be taxed as a partnership or a corporation.)
The S corporation was intended to address these concerns. And while over the years the mechanics have changed, the basic principle remains the same: An S corporation is normally not subject to entity-level taxation. Instead, the S corporation’s income and deductions are allocated to the shareholders pro rata (sort of, but not quite, like a partnership).
“But how does a corporation become an S corporation?” you might ask. It’s pretty simple. An S corporation is a “small business corporation” that’s made an election to be an S corporation. In contrast, a corporation that’s not an S corporation is a C corporation. (In answer to the title of this post, “S” and “C” refer to the sub-chapters of the Internal Revenue Code governing the tax treatment of each type of corporation.)
A “small business corporation,” in turn, is defined as a domestic corporation (meaning a corporation created or organized under the law of the United States) that is not ineligible and that doesn’t have (1) more than 100 shareholders; (2) a shareholder that is not an individual or certain estates or trusts (i.e., a corporation, partnership, limited liability company, or other business entity); (3) a shareholder that is a nonresident alien; or (4) more than one class of stock. Corporations ineligible to become S corporations include certain financial institutions, insurance companies, and companies engaged in international business.
All of these restrictions point towards the fatal flaw (Kryptonite?) of S corporations: They’re easily breakable. For instance, a corporation will cease to be an S corporation if a stops being a small business corporation as defined above. A corporation will also cease to be an S corporation if the company has accumulated earnings and profits for three consecutive tax years and more than 25 percent of the company’s gross receipts for each of those three years are passive investment income. Once a corporation stops being an S corporation, it becomes a C corporation and thus potentially subject to double taxation.
On the plus side, there may be some potential to reduce employment taxes paid on behalf of owners compared to the self-employment taxes due from owners of partnerships and limited liability companies. Also, S corporations may be easier and cheaper to administer than other business entities.
So, to sum up, there are some good things and some bad things about operating as an S corporation. Business owners need to look through all the law and facts before making the leap.