What Does Subchapter S Election Mean?

Generally speaking, Subchapter S election means that for federal tax purposes the corporation does not exist.

A general C corporation that has "elected" S corporation status passes earnings and losses through the corporation and is reported on the owners' personal income tax return. This avoids the "double taxation" feature of general businesses and close corporations.

Requirements for Subchapter S Election

Only a “Small Business Corporation”, as defined under this section of the Code, may elect to have the rules of Subchapter S apply to it and its shareholders. In fact, a corporation may lose such status if it ceases to meet the Code’s requirements of a small business corporation.

A corporation or other entity eligible to elect to be treated as a corporation may elect to be an S corporation only if it meets all of the following tests:

1. It has no more than 100 shareholders. You can treat an individual and his or her spouse (and their estates) as one shareholder for this test. You can also treat all members of a family and their estates as one shareholder for this test. All others are treated as separate shareholders. 

2. Its only shareholders are individuals, estates, exempt organizations described in section 401(a) or 501(c)(3), or certain trusts described in section 1361(c)(2)(A).

3. It has no nonresident alien shareholders. All shareholders must be citizens or residents of the United States. Limited liability companies offer nonresidents many of the same advantages U.S. residents enjoy with S corporation status. You can learn more about limited liability companies here or learn how to start an LLC here. 

4. It has only one class of stock. It is important to note that shares differing solely in voting rights do not constitute different classes of stock. Thus, an S corporation can issue non-voting stock in addition to its voting stock.

There are several additional tests, however these are the main ones. Should you meet these qualifications and wish to proceed, you may find the full list of requirements as well as additional clarification on the above rules on page two of the IRS Form 2553 instructions. 

The Difference Between an S Corp and a C Corp

The main difference between a C Corp and an S Corp is that C Corps pay taxes at the corporate level and shareholder level (commonly referred to as 'double taxation'), while S Corps are pass through entities.

The other important difference is that C Corps have no restrictions on ownership, while S Corps restrict the number of shareholders to 100 and shareholder residency to the US.  For those reasons, S Corps are more commonly small businesses.

How to Elect Subchapter S Status

In order to be taxed initially as a Subchapter S corporation, the stockholders must complete I.R.S. Form 2553 prior to the 15th day of the third month of the corporation’s existence.

Terminating Subchapter S Election

Once made, the Subchapter S election remains in effect until it is terminated either voluntarily or involuntarily by failure to meet certain requirements. Once a Subchapter S election is terminated, the corporation may not make a new election for five years.

Advantages of Subchapter S Election

There are many advantages to Subchapter S Election including:  

• Avoiding double taxation
• Reducing self-employment taxes
• Simple transfer of ownership
• Limiting liability of shareholders
• Able to use the cash method of accounting

Check out an easy infographic on the advantages of subchapter S corporations here. 

If you have any questions about forming a Delaware S Corporation, please feel free to contact us or call us at 800-223-3928. If you're ready to start your Delaware S Corporation today, you can do that via our easy online ordering system here.