Most people decide to incorporate their small businesses for the protection it gives them from personal liability for most business debts and obligations. The protection offered by operating a business as a corporation comes at a price. Corporate income is subject to double taxation: once when the corporation pays income taxes, and the second time when the shareholders pay income taxes on dividends they receive. Corporations that meet the restrictions for Subchapter S status can avoid double taxation. Income and losses of a Subchapter S or, as it is more commonly called, an S corporation, are passed through the corporation to the shareholders to be reported on their personal income tax returns, and the shareholders pay individual income tax rates that are lower than corporate rates.
Effect of Subchapter S Election
If you want to incorporate a business, you do so by filing in the state in which the corporation will be located and complying with the corporation laws of that state. A corporation is referred to as a C corporation for federal income tax purposes when it is first set up. Unless it elects to be treated as a Subchapter S corporation, all income and losses will be reported on the corporation's federal income tax return. Taxes are paid at the applicable corporate income tax rates. If the election is made to file as a Subchapter S corporation, the income and losses are passed through the corporation to be distributed among the shareholders. The shareholders report the income and losses on their personal income tax returns and pay at individual income tax rates.
An S corporation must be a domestic corporation, and not a corporation formed in another country. It can have no more than 100 shareholders, none of whom can be a partnership, corporation or nonresident alien. Certain financial institutions, insurances companies, and domestic international sales corporations cannot elect to be treated as S corporations.
Classes of Stock
An S corporation can have only one class of stock. A corporation with a second class of stock does not qualify as an S corporation. Distributions of income and losses cannot be allocated to different classifications of shareholders.
If you are a shareholder-employee of an S corporation, you must be reasonably compensated for the services you perform. If not, the Internal Revenue Service may treat distributions and other non-wage payments as wages. This is to prevent shareholders who work for the company from avoiding income taxes by attempting to treat taxable wages as nontaxable distributions.