Tax Pros and Cons of the Subchapter S Election

New business owners need help to address questions about business taxes. The answers all depend on the type of business they set up. Sole proprietorship? Corporation? The choices can be confusing.

I recently blogged about operating as a sole proprietor. I described it as the simplest way to establish a business. But what about operating as a Subchapter S Corporation? That could be an option, but it’s not for everyone.

A business must qualify to take the Sub-S Election. Requirements for the election include having 100 or fewer domestic shareholders and issuing one class of stock. Some advantages are limited shareholder liability and no double income taxation. Disadvantages include additional legal documents and tax forms and no outside capital funding.

Deciding to take the Sub-S Election generally boils down to three factors:

1. Capacity for Additional Recordkeeping

A Sub-S Corporation is required to file a separate federal income tax return, IRS Form 1120S. The Sub-S employs any shareholders, requiring federal, state, and local payroll processing and reporting. Shareholders also receive an IRS Form K-1 for their pro rata share of non-wage income and expenses. Shareholders are responsible for tracking the basis of their shares, which impacts how distributions are taxed.

2. Ability to Manage How Income and Losses are Reported

To prevent underpayment of payroll taxes, the IRS requires that wages paid to shareholders be “reasonable.” As noted above, the tax treatment of distributions reported on IRS Form K-1 depends on the basis of the shareholder’s shares. While complex, the Sub-S Election provides tax planning opportunities for shareholders.

3. Possibility for Favorable Tax Treatment upon Sale

Any gain on the sale of Sub-S Corporation shares qualifies for more favorable capital gains rates. The tax treatment the gain or loss upon sale for each shareholder depends on her or his share basis.

Taxes are complicated. Sub-S Corporation rules are particularly complex. Knowing the right forms and when to file them can be overwhelming. Consulting a qualified tax professional helps to sort it out, and decide what’s best for you and your business.