S Corp Tax Status: Everything You Need to Know

The S-Corp tax status is a special tax status. When electing to operate as an S-Corporation, the corporation itself does not pay taxes on its income.3 min read

The S-Corp tax status is a special tax status. When electing to operate as an S-Corporation, also known as an S-Corp, the corporation itself does not pay taxes on its income. The owners and shareholders are taxed one time as individuals on their tax returns; this helps avoid double taxation.

How Have Tax Status Options Changed for Businesses?

At one time, there were only two options to choose from in regards to tax status when forming a business. C corporations enjoyed liability protection but faced double taxation because the corporation was taxed and then the individual owners and shareholders were required to report income and were taxed on an individual level as well.

The other option was to operate under a partnership or sole proprietorship status. Doing so meant the owners gave up liability protection but enjoyed individual taxation and not double taxation. Still, neither option was ideal for family-owned or small businesses.

When Did S-Corp Tax Status Become Available?

Fortunately, in 1946, at the suggestion of the Department of Treasury, S-Corp status was presented as a third option, which allowed businesses to avoid double taxation while having comprehensive liability protection. Fast forward a few years, and Democratic Congress retorted and accused President Dwight Eisenhower of favoring big corporate interests over the little guy, thus accusing him of “trickle-down economics."

During this economic centralization, economists like John Kenneth Galbraith claimed America's economic future was a grand balance of power between Big Labor, Big Business, and Big Government. Both Republicans and Democrats agreed that a few wealthy, multinational corporations were gaining too much economic power.

As a response to alarming concerns and warnings, President Eisenhower accepted the Treasury's proposal to include an additional option for S-Corp status. Finally, in 1958, subchapter S was created at the recommendation of Eisenhower. Democratic Finance Chairman Harry Byrd led the movement by adding the tax code as part of a larger package of miscellaneous tax items.

What Are the Benefits of S-Corp Tax Status?

Four advantages of s-corp status are:

  • Flow-through taxation.
  • Perfect for companies providing services as a product.
  • Good privacy protection.
  • Ideal for enhanced income-splitting potential.

Entrepreneurs who elected S-Corp status avoided double taxation and agreed to operate as a domestic enterprise only. In addition, the status meant those electing S-Corp status could have one class of stock and a limited number of shareholders. More so, there would be restrictions on who those shareholders could be.

If you're wondering how momentous the creation of S-Corp status was, consider the fact that in 1958 the top income tax rate was 91% for individuals and 52% for corporations. In other words, dividends paid by a C corporation to shareholders who had a high income could face a tax rate of 96%. Even families with a median income could be mandated to pay federal taxes at a rate of more than 60%.

How Did S-Corp Tax Status Fuel the American Economy?

The S-Corp status option was a huge step in encouraging people to start small businesses and family-owned companies. Eliminating the double taxation was a substantial aid to small and family-owned businesses.

Small businesses are the key to the American economy, and S Corporations are the cornerstone of the small business community. Even a half-century later, S-Corps are the most popular business structure in America. In 2014, the IRS estimated 4.6 million S-Corp owners in the United States. This number is over twice as many as C corporations.

Are S-Corp and LLC the Same Thing?

The S-Corp population has continued to grow, while most rules governing the S-Corp status remain the same today. Furthermore, when forming a new business, owners can take advantage of creating a company that qualifies as a limited liability company, also known as an LLC. While both provide owners with limited liability protection, LLCs and S-Corps are two totally different things.

A common misconception is that an S-Corp is a type of business, but actually, it's a tax status. S-Corp refers to Subchapter S of the IRS code. This simply means if a business can meet the requirements, it can be taxed as a partnership. Partnerships don't pay double taxes, and you can achieve this as well through the formation of an LLC.