Part 25 – Reflections on the “S Corporation” exemption to the Sec. 965 @USTransitionTax – Hat Tip to @SCorpAssn (Part B)

cross-posted from citizenshipsolutions

Part A is here .

1. What exactly is an S Corporation?

An “S corporation” is a corporation which elects a specific kind of tax treatment under the Internal Revenue Code. It is NOT a type of corporation. Rather it is the “tax treatment” used by a corporation. (A corporation can be incorporated in any state.)

The following tweet referencing an excellent article from Wolters Kluwer explain this point.

The first thing to remember is that an S corporation is simply a for-profit corporation that elected to be taxed under Subchapter S of the Internal Revenue Code, making it a “pass-through” entity for tax purposes. It is incorporated under and governed by the same state corporation laws as a corporation that was not eligible for S corporation tax status or whose shareholders chose not to elect that status. Therefore, an S corporation has the same non-tax advantages as a regular corporation. (A regular corporation is also referred to as a C corporation when discussing its tax status because it is taxed under Subchapter C of the Internal Revenue Code).

Because an S Corporation is a corporation with a specific kind of tax treatment (the profits are passed through to the shareholders), one can say that an S Corporation is really a creation of the Internal Revenue Code (On The Third Day Congress Created The S Corporation).

2. How the requirements of an S Corporation reflect that that S Corps are the “small business corps” of America

Since the S Corporation is a creation of the Internal Revenue Code, we look to the Internal Revenue Code to learn the requirements to be an S Corporation. The S Corporation is defined in Internal Revenue Code Sec 1361.

Section 1361 includes:

(a) S corporation defined
(1) In general
For purposes of this title, the term “S corporation” means, with respect to any taxable year, a small business corporation for which an election under section 1362(a) is in effect for such year.

(2) C corporation
For purposes of this title, the term “C corporation” means, with respect to any taxable year, a corporation which is not an S corporation for such year.

(b) Small business corporation

(1) In general For purposes of this subchapter, the term “small business corporation” means a domestic corporation which is not an ineligible corporation and which does not—

(A) have more than 100 shareholders,
(B) have as a shareholder a person (other than an estate, a trust described in subsection (c)(2), or an organization described in subsection (c)(6)) who is not an individual,
(C) have a nonresident alien as a shareholder, and
(D) have more than 1 class of stock.

(Interestingly this sounds very much like the requirements to be a Canadian Controlled Private Corporation in Canada. Note also that most Canadian Controlled Private Corporations are “per se” corporations under the entity classification rules and cannot be treated as disregarded entities under U.S. tax law.)

It is clear that this does not and could not describe a large publicly traded corporation like Google or Apple. Notice also that S Corporation shareholders cannot include nonresident aliens.

An S Corporation is designed to provide the corporate benefits of limited liability coupled with the simplicity and tax benefits of being taxed as an individual.

3. How the S Corporation is taxed and why that taxation is consistent with the S Corporation as an entity for small business

To put it simply:

An S Corporation is a “pass through” entity. The profits (passive income excepted) of the corporation are taxed directly to the individual. This has the effects of:

– avoiding double corporate taxation (the profits are taxed only once instead of first at the corporate level and second at the individual level);

– making the S Corporation a bad vehicle for the accumulation of income for expansion, etc. (but the devil is always in the details)

From the IRS perspective:

This is very reasonable and reflects that an S Corporation is really more like an individual than an Apple or a Google. It is reflected by the following history of the S Corporation

4. An interesting history of the S Corporation

At, the S Corporation Association of provides an interesting history of the origins and evolution of the S Corporation which includes:

The History and Challenges of America’s Dominant Business Structure

Before Congress created S corporations, entrepreneurs had two choices when starting a business. They could form a regular C corporation, enjoy liability protection, but face two layers of federal tax at the corporate and individual level. Or they could choose a partnership or sole proprietorship, enjoy a single layer of taxation at the individual level, but sacrifice the umbrella of liability protection.

Neither choice was optimal for small and family owned businesses. In 1946, the Department of Treasury suggested a third option – merging a single layer of federal tax with comprehensive liability protection.

A few years later, Republican President Dwight Eisenhower found himself under fire from the Democratic Congress for practicing “trickle-down economics” and favoring big corporate interests over the little guy.

At the same time, Republicans and Democrats were increasingly alarmed that too much economic power was being consolidated into the hands of a few wealthy, multinational corporations. This economic centralization was characterized by economists like John Kenneth Galbraith, who saw America’s economic future as a grand balance of power between Big Labor, Big Business, and Big Government. Private enterprise was viewed as a thing of the past.

In response to these concerns, Eisenhower embraced the Treasury proposal and recommended the creation of the small business corporation to Congress. In 1958, led by Democratic Finance Chairman Harry Byrd, Congress acted on Eisenhower’s recommendation, creating subchapter S of the tax code as part of a larger package of miscellaneous tax items. In exchange for enjoying a single layer of tax, entrepreneurs electing S corporation status agreed to the following limitations:

They were required to be a domestic enterprise; They were required to have a limited number of shareholders; They were limited by who those shareholders could be; and They could have just one class of stock.

You can continue and read more history here

John Richardson