Subchapter S Tax Status for a Delaware Corporation or LLC

When it comes to taxes, businesses are always seeking ways to minimize their tax liability. Around 70 years ago, entrepreneurs had limited options in structuring their entities from a tax perspective. They could opt for a standard C Corporation, but this subjected the company to double taxation, both at the corporate level and for individual owners. Although this choice offered asset protection through a corporate entity, it frequently led to unfavorable taxation for smaller businesses.

Alternatively, entrepreneurs could choose to operate as an unincorporated entity, such as a sole proprietorship or partnership. While these structures offered the desired flow-through taxation, they lacked the asset protection provided by a corporation.

In 1958, the Treasury Department introduced the Subchapter S tax status, which brought significant advantages but also came with certain restrictions. This designation provided a viable solution for businesses, offering a balance between tax benefits and asset protection.

Tax Benefits of Subchapter S Status

Once a business has successfully elected Subchapter S status, it becomes a pass-through entity for tax purposes. This means that the profits and losses of the business are passed through to its shareholders or members, who then report them on their personal tax returns. As a result, the business itself does not pay federal income tax, which can lead to significant tax savings for both the business and its owners.

By eliminating the double taxation that occurs with C corporations, Subchapter S status allows small businesses to retain more of their earnings and reinvest them back into the company. This additional capital can be used to fuel growth, hire more employees, or invest in new technologies and equipment.

Furthermore, the pass-through nature of Subchapter S status provides flexibility in the distribution of profits to the shareholders or members. Unlike C corporations, where dividends are subject to double taxation, shareholders or members of an S corporation can receive distributions in a tax-efficient manner. This can be particularly advantageous for business owners who rely on business income as their primary source of personal financial support.

Obtaining Subchapter S status can be a strategic tax planning move for eligible businesses, offering significant benefits in terms of tax savings, capital retention, and distribution flexibility.

How to Elect Subchapter S Status

To elect Subchapter S status, a business must file Form 2553 with the IRS.  For new companies, this means filing within two months and 15 days of its formation.

For existing companies, the form must be filed before the 15th day of the third month of the tax year in which the election will take effect. For example, if an existing business wants Subchapter S status for the 2024 tax year, the form must be filed by March 15, 2024.

Informing the Delaware Division of Corporations about the election of Subchapter S tax status is not a requirement. This election solely concerns the company and the IRS in terms of taxation.

Restrictions on Electing Subchapter S Status

While the tax benefits of Subchapter S status are attractive, there are some restrictions that businesses must adhere to if they elect this status. Some of the main restrictions include:

• The business must be a corporation or LLC formed in the US

• The business can have no more than 100 shareholders

• Shareholders must be individuals (US citizens or resident aliens), estates, or certain trusts and cannot be corporations or partnerships

• The business can only issue one class of stock

If a Delaware corporation or LLC meets these requirements, it can file Form 2553 with the IRS to elect Subchapter S status.

Subchapter S status offers significant tax advantages for Delaware corporations or LLCs. However, there are restrictions that must be met in order to elect this status. Business owners should consult with a tax professional or attorney to ensure they meet all requirements and properly elect Subchapter S status with the IRS for their business. By taking the necessary steps, businesses can enjoy the tax benefits of Subchapter S and potentially increase their profits.

If you’d like to learn more about applying for Subchapter S tax status for a new business, be sure to read our blog about Filing S-Corp Status on a New Delaware Corporation.