What is an S Corporation (S Subchapter)?

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Definition:

The term S corporation refers not to the structure of a company, but to the manner in which they pass income along to shareholders to avoid double taxation.

🤔 Understanding S corporations

An S corporation is a company that meets the Internal Revenue Service (IRS) requirements to file taxes under the Internal Revenue Code Subchapter S. This special tax status allows an S corporation to avoid paying corporate income taxes by passing along income and deductions to the shareholders, to avoid double taxation. Either C corporations or limited liability companies (LLCs) may elect to file taxes under the S corporation status if they meet the IRS requirements. To qualify, the firm must have no more than 100 shareholders that are either individuals, trusts, or estates. All shareholders must be U.S. persons. The company must also be a domestic corporation, meaning it is formed or organized in the United States. Filing taxes under Subchapter S can potentially help a corporation save in taxes.

Example

Let’s say that Susan, the only owner (shareholder) of a small corporation, is preparing to file her taxes on behalf of her company. She realizes that, as it currently stands, she’ll have to pay income on her earnings twice — First, Susan’s company will pay corporate income on her company’s profits. Then she’ll pay personal income taxes on the same profits if she receives them as a dividend payment. Susan decides to file taxes as an S corporation so she can pay income taxes on the profits once instead of twice.

Takeaway

Filing taxes as an S corporation is like playing the same game with different rules…

Suppose that you’re playing a board game with a friend. You’re both playing the same game but by slightly different rules. That’s kind of how it is when a corporation or LLC files taxes as an S corporation. Technically they’re the same type of business as any other corporation or LLC, but they file taxes by different rules.

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How does an S corporation work?

An S corporation is a company that files taxes under Internal Revenue Service (IRS) Subchapter S. This tax filing status allows corporations to avoid double taxation by passing their corporate income and losses along to shareholders.

Most corporations have to pay corporate income taxes to the IRS at a flat tax rate of 21%. Then, they may distribute their after-tax profits to shareholders in the form of dividends. Shareholders then generally have to pay income taxes on those dividends when they each file their income tax returns. As a result, those profits have been taxed twice — First as corporate income and again as dividend income to shareholders.

When a corporation files taxes as an S corporation, it doesn’t pay corporate income taxes. Instead, it passes its income and expenses on to shareholders. Then, each shareholder pays individual income taxes on their share of the profits (or may be entitled to deduct the losses).

Limited liability companies (LLCs) can also elect to file taxes as an S corporation, but many do so for different reasons. LLCs, which the IRS taxes as either sole proprietorships or partnerships, do not pay the same double taxation that corporations do. If you are the sole owner of an LLC, you only pay income taxes once on the money your business earns.

But LLC owners have to pay self-employment taxes, which means they pay twice as much in FICA taxes (the combination of Social Security and Medicare taxes) as traditional employees. Most employees pay only half of their FICA tax, while their employer pays the other half. Self-employed individuals have to pay both portions.

But how does that relate to filing as an S corporation?

An LLC owner filing taxes as an S corporation would pay themselves a reasonable salary. This salary would be subject to self-employment taxes. But the company’s remaining net earnings passed on to the owner will not be subject to self-employment taxes.

How do you become an S corporation?

To qualify for S corporation status, a company has to meet several requirements put forth by the Internal Revenue Service (IRS). First, the company must be domestic — This means it must be formed or organized in the United States.

An S corporation also has to meet specific shareholder requirements. First, the company can have no more than 100 shareholders. Those shareholders can be either individual people, trusts, or estates. None of the shareholders may be partnerships, corporations, or non-resident aliens. Finally, the company can have no more than one class of stock.

There are some types of companies that are ineligible from qualifying as an S corporation, even if they meet the other requirements. These companies include some financial institutions, insurance companies, and domestic international sales corporations.

If a company meets all of these filing requirements, they can fill out the paperwork to become an S corporation. They must file IRS Form 2553, Election by a Small Business Corporation. To qualify, all shareholders must agree and sign the form.

For a corporation that sells stock shares, the shareholders would include anyone who owns stock in the company. For a limited liability company (LLC), the shareholders would only include the single owner or partnership members, since LLCs do not sell stock shares.

What are the advantages and disadvantages of filing under subchapter S?

For many companies, choosing to file taxes as an S corporation under Subchapter S of the Internal Revenue Code can be extremely beneficial. Registering as an S corporation has many of the advantages of a traditional corporation. You typically have the same corporate structure and limited liability. You also have the ability to raise capital by selling shares of stock in the company.

At the same time, you avoid one of the most significant downsides of a corporation — Double taxation. Instead, corporations can avoid paying double taxes by passing along profits and losses to shareholders.

Filing as an S corporation also has its downsides, though. First of all, filing to become an S corporation is no walk in the park. There are strict requirements you and your shareholders must meet. Plus, all of the shareholders have to agree to the change. There’s always the chance that you won’t meet the IRS requirements or that a shareholder will say no.

Another downside for an S corporation is that because of the perks that come with it, you could face more scrutiny from the IRS.

The S corporation status can also be problematic for S corporation shareholders. When the company is an S corporation, the shareholders pay income taxes on their portion of the profits when they file their individual tax returns.

But there’s a catch — The company doesn’t have to distribute the profits to shareholders. They could retain them as operating capital. As a result, shareholders pay income taxes on money they did not receive.

What is the difference between an S corporation vs. a sole proprietorship vs. an LLC vs. C corporation?

When you decide to start a business, there are several different business structures you can choose from. The most basic of those structures is a sole proprietorship.

A sole proprietorship is an unincorporated business that an individual owns. There’s no paperwork to fill out to become a sole proprietorship — You automatically become one when you start earning money from business activities.

In a sole proprietorship, there is no legal distinction between you and your business. Any revenue the company earns is your income, and you must pay personal income taxes on those earnings.

While it might seem convenient to be a sole proprietor, there are downsides. Because there is no legal distinction between you and your business, you are liable for any debts and obligations the company has. If someone sues your business, they’re suing you.

One step up from a sole proprietorship is a limited liability company (LLC). To become an LLC, you must file the appropriate paperwork with your state’s government.

An LLC is similar to a sole proprietorship, except there is a legal distinction between you and your business. The debts and obligations belong to your business, not to you. LLCs with a single member act just like sole proprietorships for tax purposes, meaning you pay taxes on your business’s income as personal income.

After LLCs are C corporations — This is what your business becomes when you file articles of incorporation. C corporations are separate entities from their owners. C corporations pay corporate taxes on their profits, and then owners pay personal income taxes on the profits they take home. C corporations have shareholders, who have become part owners of the company by purchasing stock.

Finally, we have S corporations. Either LLCs or C corporations can qualify to file taxes as an S corporation. It does not change the structure of the business, only the way they pay taxes. Not all states recognize the S corporation status, meaning you might pay taxes as an S corporation at the federal level and as a C corporation at the state level.

When it comes to deciding which company structure is right for you, you should consider the size of your business, the level of risk you expect your business to take on, and how much of a personal connection you want to your business.

A sole proprietorship might seem like a great idea, but it's often best for those with little risk of being on the receiving end of a lawsuit. It’s not much extra effort to become an LLC instead, and you have the protection of the legal separation between you and your business.

Corporations have the same limited liability protection as LLCs, but with some other differences. For one, they have to file articles of incorporation with their state. Also, they can raise money by selling shares of stock. But for a business owner that wants a personal connection to their business, having a corporation with shareholders and a board of directors could limit that.

Ultimately, it all comes down to what is best for you and your business. You may be well advised to discuss the issue with a tax professional and/or attorney.

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New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

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© 2022 Robinhood. All rights reserved.