A Subchapter S corporation is a legal entity used by many small businesses to conduct business. As a corporation, it is separate from, and independent of, its owners, the shareholders. The title, “Subchapter S corporation,” or “S corporation” as it is commonly known, derives from the U.S. Internal Revenue Code.
Creation and Maintenance of an S Corporation
In order to create an S corporation, Articles of Incorporation must be filed with the state in which the S Corporation intends to operate. S corporation status is elected with the federal, and sometimes state, government. Unless limited by its Articles, an S corporation exists perpetually. However, an S corporation must comply with standard corporate procedures, such as the holding of annual meetings.
An S corporation’s shareholders elect a board of directors which, in turn, hires officers to conduct the corporation’s daily business. There are some special limitations on an S corporation, however. For example, the S corporation may have no more than 100 shareholders. Additionally, all of its shareholders must be U.S. citizens or residents. An S corporation can issue only common stock and one class of stock (different voting preferences within the class are allowed).
The primary advantage of S corporations is in the area of taxes. The federal government, and many states, do not directly tax S corporations. Instead, the profits and losses are reported on the shareholders’ tax returns. This is known as “pass-through” taxation.
Another advantage enjoyed by the owners of an S Corporation is that of limited personal liability. The creditors of an S corporation cannot look to the personal assets of a shareholder to satisfy a judgement against the business.
One of the disadvantages is that, unlike a C corporation where profits may not be immediately distributed, an S corporation owner is liable for the taxes on the business’s income whether or not profits are distributed. In addition, because the shareholder can demand distributions from the business in order to pay their proportional taxes, there can sometimes be little money left over for reinvestment in the corporation. Another disadvantage is that fringe benefits for most shareholders, such as health and life insurance, are not tax deductible.