Choosing a Business Form 253elected to be taxed similarly to a partnership. Thus, like the partnership, it is
not a separate taxable entity and files only an informational return. Profits ap-
pear on the tax returns of its stockholders in proportion to shares of stock
owned, regardless of whether those profits were distributed to the stockhold-
ers or retained for operations. Losses appear on the returns of the stockholders
and may potentially be used to shelter other income.
Although the subchapter S corporation is often referred to as a small
business corporation, the size of the business has no bearing on whether this
election is available. Any corporation that meets the following tests may, but
need not, elect to be taxed as a subchapter S corporation:
- It must have 75 or fewer stockholders.
- It may have only one class of stock (although variations in voting rights
are acceptable). - All stockholders must be individuals (or certain kinds of trusts).
- No stockholder may be a nonresident alien.
- With certain exceptions, it may not own or be owned by another
corporation.
The subchapter S corporation is particularly suited to resolving problems
presented by certain discrete situations. For example, if a corporation is con-
cerned that its profits are likely to be too high to eliminate double taxation
through compensation to its stockholders, the subchapter S election eliminates
the worry over unreasonable compensation. Since there is no tax at the corpo-
rate level, it is not necessary to establish the right to a compensation deduc-
tion. Similarly, if a corporation has nonemployee stockholders who insist upon
current distributions of profit, the subchapter S election would allow declara-
tion of dividends without the worry of double taxation. This would undoubt-
edly be attractive to most publicly traded corporations were it not for the
75-stockholder limitation.
Many entrepreneurs have turned to the subchapter S election to eliminate
the two layers of tax other wise payable upon sale or dissolution of a corporation.
The corporate tax other wise payable upon the gain realized on the sale of cor-
porate assets is eliminated by the use of the subchapter S election as long as the
election has been in effect for 10 years or, if less, since the corporation’s incep-
tion. Finally, many entrepreneurs elect subchapter S status for their corporations
if they expect to show losses in the short term. These losses can then be passed
through to their individual tax returns to act as a shelter for other income. When
the corporation begins to show a profit, the election can be reversed.
Limited Partnerships
The tax treatment of limited partnerships is much the same as general partner-
ships. The profits and losses of the business are passed through to the partners in
the proportions set forth in the partnership agreement. It must be emphasized