A Short Primer on Subchapter S Corporations

This website, which grew out of a graduate tax class Steve taught at Golden Gate University's tax program several years ago, provides you with all sorts of background on S corporations, including do-it-yourself downloadable kits (with forms and instructions) that you can use to set up one of these entities yourself. (More on how to get a DIY kit in a minute...)

But before you start poking around the FAQ (a great place to dig deeper into subject matter) or read up on the steps required to form an S corporation in your home state, however, let us give you a bit of really big picture background information.

First Thing To Know: Not Really a Corporation

We make this point again and again at this website, but as you begin your research let us clear up a point of confusion: An S corporation is not really a corporation.

Here's the history so this statement makes sense. Congress added Subchapter S (the relevant chunk of tax law) to the Internal Revenue Code more than fifty years ago in 1958. This subchapter, which was based on a proposal that had been made a few years earlier by President Eisenhower, gave corporations with just a handful of individual shareholders the option to be taxed like partnerships. This meant among other things that the corporation wasn't taxed on its profits. Rather, the corporation allocated its profit to its owners, and then the owners got taxed.

At the time, only corporations could make the election to use the "partnership-like" accounting rules contained in the new Internal Revenue Code sections. But that wasn't a problem when, for all practical purposes, only sole proprietorships, partnerships and corporations even existed for business tax law purposes.

Predictably, then, people started calling these corporations which made the election to use the rules "Subchapter S corporations" and then, later, "S corporations" or "S corps". But all along, these entities were really just corporations that used a particular set of accounting rules found in a subchapter of tax law.

Now, fast forward four decades to the 1990s. When state legislatures starting allowing people to form new-and-improved business entities like limited liability companies, the IRS (after a few years of handwringing) decided to allow these entities to also use the same "Subchapter S" accounting rules if they wanted.

Note: The Wyoming legislature was the first to create the laws that allowed for a limited liability company, and did so in 1977. Over the next two decades, roughly, every other state as well as the District of Columbia followed suit.

Once the IRS opened the door to this option, not just corporations but also LLCs and even other esoteric entities like limited liability partnerships began making the election to use the Subchapter S accounting rules.

Today, accordingly, you hear people use the phrase "S corporation" to refer not only to corporations that use the Subchapter S accounting rules, but also to limited liability companies and even other entities like limited liability partnerships that use the same rules.

How S Corporations Save Taxes

We talk in more detail about how the Subchapter S accounting rules save taxes in many of the FAQ articles. But for the great bulk of small business owners, the tax savings stem from a reduction in payroll taxes.

You can (and should) read more about this topic here but let us give you a quick description with round numbers.

If you're a sole proprietor making $100,000 a year in profits or a partner in a partnership and your share of the profits equal $100,000, you might pay about $12,000 in income taxes and about another $13,000 in self-employment taxes.

If you incorporate the business or reform it as a limited liability company and then elect to use the Subchapter S accounting rules, you will still pay the same $12,000 income taxes or whatever. But you will only pay self-employment taxes on the part of the profit you call "wages".

Typically, businesses using the Subchapter S accounting rules pay owners $40,000 a year (roughly) in wages and then pay out the rest of the profits in either distributions or tax-free benefits. If you did that, you would pay about $6,000 in self-employment taxes. And that's where the savings come from. You now pay $6,000 a year, while you used to pay (in our example) $13,000 a year. So you're up $7,000 a year.

Note: If you could cut your self-employment taxes by $7,000 a year for the years you work and you save the money into something like a small business pension plan, you would end up with something well over a million dollars in present-day, adjusted-for-inflation amounts.

Will the Loophole Ever Be Closed?

Let's broach one other issue-the possibly that the Subchapter S tax accounting rules will be removed from the Internal Revenue Code.

The possibility exists. A couple of times in recent years (mostly seriously in 2010), Congress discussed the idea (see here, for example).

But the "loophole" has been around for decades. Further, as you now know, the "loophole" was actually proposed by a pretty centrist guy, President Eisenhowser, and has been repeatedly discussed and then re-affirmed by Congress.

Our feeling? We would totally expect that politicians (both Republicans and Democrats) will continue to debate Subchapter S regularly. But we also predict that just as they done countless times over the last five-plus decades they will in the end decide to continue the loophole they themselves created in 1958.


Additional Information You May Find Useful

If you want additional information about how to maximize the tax savings related to running a business or investment venture, you may also be interested in one of our downloadable e-books (see descriptions below). Each book covers a category of tax planning topics that easily save a business owner significant amounts of income or self-employment taxes (potentially thousands of dollars a year) and is instantly downloadable.

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