The subchapter S corporation

A Subchapter S corporation is a legal form of corporate organization, under which the liability and obligation to pay income taxes is passed through to the shareholders of the organization. Thus, the corporation itself pays no income taxes, only its shareholders.

An S corporation is taxed as a partnership, while still offering its shareholders the legal protections associated with a corporation. This form of organization eliminates the double taxation associated with a shareholder dividend from which a normal corporation suffers, where the company is taxed on its income, and then its shareholders are taxed on their receipt of dividend income from the company. Instead, all earnings of the business are passed through to and recognized by the owners on their individual tax returns.

A downside of the Subchapter S format is that the shareholders reporting the corporation's income on their tax returns must pay income taxes on those amounts, even if they have not received a distribution from the company. This means there can be considerable pressure for the company to regularly distribute cash to its shareholders, which may interfere with the formation of capital needed to grow the business.

Because of the tax pass-through status of this type of organization, the business does not report an income tax expense on its income statement, nor does it report an income tax liability on its balance sheet.

The Subchapter S type of organization is only allowed if an organization has 100 or fewer shareholders, is a domestic corporation (i.e., not foreign), only has one class of common stock, and only has certain types of eligible shareholders.

The "Subchapter S" term comes from the segment of the United States Internal Revenue Code (Chapter 1, Subchapter S) in which the rules governing the formation and operation of Subchapter S corporations is located.

Similar Terms

A Subchapter S corporation is also known as an S corporation or an S corp.