Subchapter S corporation shareholders are the owners of a corporation that falls under Subchapter S, Section 1361, Title 26, of the United States Tax Code. Commonly, called an S corporation, these companies report income to the Internal Revenue Service (IRS) according to the provisions of the Section 1362(a) of the same document. The S corporation classification, designed for small business, offers legal protection and tax advantages to the S corporation shareholders.
Under US tax law, corporations may generate income and enter contracts. They will be held responsible for the legality of their actions and may be taken to court and penalized. The efforts of a corporation generate two taxable events. The corporation’s income is taxed and then the owners of a corporation are taxed if they take any money out of the company. Corporations of this type are called C corporations.
An S corporation was conceived to promote business growth by providing the owners and investors protection from some of the risks of running a business and access to the rights of a corporation while avoiding the double taxation of a corporation. The owners or S corporation shareholders are shielded to some degree from being personally responsible for the results of business activities. The S corporation does not pay any taxes. Rather, the profit of the company is split on a prorated basis among the S corporation shareholders. The structure of an S corporation provides a midway point between the businessperson as a sole proprietor, where there is no corporate protection, and full corporate infrastructure, with the full reporting and tax responsibilities of the C corporation.
S corporation shareholders are usually individuals, married couples, or other family units, and certain trusts. Laws may change regarding the details of the number of shareholders allowed and eligible entities. Shareholders may participate actively in the business, but are not required to do so. The profit or loss of the S corporation is reported as an adjustment to income on the tax return of each shareholder. The taxable rate will be a function of the tax brackets of the S corporation shareholders, rather than the profitability of the S corporation itself.
Many new companies start business as an S corporation, but as they grow, change their tax status to that of a C corporation. The change requires the consent of shareholders and is usually irreversible. Companies cannot switch between S corporation and C corporation designations just for tax avoidance reasons.
