Business formats -- Subchapter S  corporation

•     The Subchapter S corporation is a good format in many cases. For one thing, the much-maligned "double-taxation" of regular corporations, where the corporation is liable for tax on it's profit but then the stockholders are later also liable for tax on dividends received, is avoided with a Subchapter S corporation. The S corporation is particularly appropriate for many professional services businesses, but it may suit others, too. With the S corporation, the primary result the owners will notice is that the corporation is not separately taxed on it's own profits. It is a "pass-through" form of business entity. This means that the profits, or losses, pass on to the shareholders, pro-rata, and are directly placed in a line on their personal Forms 1040 above the AGI  or Adjusted Gross Income line.

•     In order to be eligible to be a Subchapter S corporation, the Subchapter S election form must be filed with the federal government within 2 1/2 months of the date of incorporation of the business, or it will lose that right for the tax year concerned.  The Subchapter S format is available only for domestic "U.S." corporations having 75 or fewer shareholders and only one class of stock. The shareholders must be individual people or their estates, although some trusts and qualified retirement plans may qualify as shareholders. If a nonresident alien is a shareholder, the Subchapter S choice is not available. The government does not want profits to "pass through" to someone who may not reside in the U.S. and may not be a citizen and may therefore not therefore be easily pursued to pay their taxes on their share of any profit that passes through to shareholders of a Subchapter S corporation.

•     With a Subchapter S format being relatively simple, one may wonder, "Why would anyone choose to go the regular "Subchapter C" corporation route? One of the primary motivations may be that the founders plan it as a "C" from the beginning because it is going to be a corporation in which shares of stock will be offered publicly. In order to raise millions of dollars, the founders may know that more than 75 shareholders will be needed. Further, it is true that after paying salaries of officers and all employees, and all other business expenses, the "C" corporation will then have to pay tax on any profit it has, and the shareholders will have to pay taxes on any dividends declared. However, the "C" corporation does not pay out all of it's profits as dividends. Instead, it typically plans to retain earnings for corporate growth and pay out only a market rate of dividends to it's shareholders. In return, it will have access to much more investment capital than the usually smaller S corporation.

•     Unlike a partnership or LLC Limited Liability Company, and just like a C Corporation, an S Corporation needs to hold an annual meeting of shareholders. It must keep minutes of those meetings. Currently it cannot deduct as an expense, the payment of a health insurance premium for the owner, but these days, that expense can be fully deducted as an "above-the-line" item on a self-employed individual's Form 1040, anyway.  Like a C Corporation, the S Corporation can pay salaries with all the usual withholdings to the one or more shareholders who work for it as employees. Unlike a C Corporation, however, the one or more shareholders of an S Corporation must also report each year their share of the profits after such expenses as salaries, as will be reported to them on the Schedule K-1 and none are "retained" separately by the S Corporation.

•     A Subchapter C corporation may retain earnings remaining after paying out salaries and other business expenses. These retained earnings will not normally be taxed to the shareholders.  Instead, the retained earnings will be taxed at the corporation taxation rates. The earnings will be retained or held in the corporate accounts to be invested in corporate business. If the owners eventually plan to take the business public or sell stock, it is best to start out from the very beginning as a C Corporation. While the business may not be public at first, the owners may plan to take it public later. In that case, too, they should plan from the very beginning not only to have their taxes prepared by professional accountants, but also to have annual financial audits done on their records by large accounting firms designated by the SEC or Securities Exchange Commission for auditing records of publicly held corporations. This will facilitate the review of past business practices and past accounting that will be necessary when they later prepare to offer stock to the public.

•     The Subchapter S form of corporation will be good for the business that does not plan to have many stockholders, does not plan to go public, where the owners feel the profits will not be so huge that it would be ridiculous to pay individual income taxes on their shares each year, and where there may be net losses which the owners would like to use to offset their regular income from other sources. Where that format is desired, the Subchapter S corporation election should be made as soon as the Articles of Incorporation are filed, to avoid possibly missing the 2 1/2 month deadline.