The IRS has never been in the business of clarity, and s-corporations prove just that. It’s understandable why people other than tax attorneys and accountants think that s-corporations are a type of entity, although they are not.
A Case of Poor Naming
A corporation is a type of entity. It is something you create through a secretary of state. Limited liability companies, nonprofit corporations, and limited partnerships are other types of entities.
An s-corporation, on the other hand, is not a type of entity. You do not submit a form to a secretary of state to create an s-corporation.
An s-corporation is a tax structure. By making an election (an election is a fancy word for “decision”) to be taxed as an s-corporation, an owner of a corporation or a limited liability company can obtain the IRS’ okay to treat the company’s taxes in a certain way.
When the s-corporation tax structure was first enacted in 1958 it was contained in Subchapter S of the Internal Revenue Code. It evolved into being known as an S Corporation simply because of the subchapter it was contained in, but it had nothing to do with a new kind of corporation. In fact, if LLCs existed in 1958, I doubt that s-corporations would be called s-corporations at all. They’d probably be called s-entities or something equally as awkward but at least not misleading.
S Corporations Are Tax Structures
The IRS defines S Corporations (WARNING: SUPER ADVANCED MATERIAL: the IRS doesn’t generally put a hyphen between the ‘s’ and ‘corporation’) as, “corporations that elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes.” This means that generally, instead of having to pay taxes at the level of the corporation and then again at the shareholder level, tax will only be applied once at the shareholder level (or member level if it’s an LLC that elects to be taxed as an s-corporation).
To expand, S Corporations are tax elections that corporations choose to have for various reasons. The legal and tax aspects of a corporation are not always one and the same, and the S Corporation tax election is a prime example of just that. You’ll be a long way down the path of reducing complexity in your legal life if you take the time to appreciate the distinction between entity type and tax treatment. You can be a corporation taxed as an s-corporation or an LLC taxed as an s-corporation or an LLC taxed as a sole proprietorship (this doesn’t mean you lose legal liability protection!), an LLC taxed as a corporation (or what we sometimes call a “c-corporation” to distinguish it from an s-corporation even though that is unnecessary.
A corporation can choose to be taxed conventionally, where both legal structure and tax structure are equal, or they can elect to be taxed differently by doing something like filing under Subchapter S.
Financial, legal, and tax considerations for a business aren’t easy to navigate, although they don’t need to be ridiculously complex either. Most of these things can be simplified considerably.
If you need some help sifting through complexity in your legal or business life, call me.