When the organizers of a new corporation file the Articles of Incorporation, the state government grants the organizers a charter and the new entity comes into existence. This charter grants the new entity the right to conduct business, sell capital stock, and own property, among other rights. But, when the charter is granted, the charter does not declare that the entity is an “S” corporation or a “C” corporation.
In fact, it is not possible to incorporate an “S” corporation or “C” corporation. Why?
The classification of a corporation as an “S” corporation or a “C” corporation is a tax determination recognized by the Internal Revenue Service, not a type of corporation created by state government.
The tax status of a corporation determines how income will be taxed. Income from a subchapter “C” corporation is taxed twice – the corporation pays taxes on the net income of the corporation and when distributions are made to the owners, the owners pay taxes on those distributions. Corporate Income from a subchapter “S” corporation is only taxed one time: at the shareholder level.
If the shareholders take no action with the Internal Revenue Service, the corporation will be taxed as a “C” corporation by default. The “C” designation gets its name from Title 26 of the United States Code, Chapter 1, Subchapter C – “Corporate Distributions and Adjustments.”
To become a Subchapter “S” corporation, all of the shareholders of the corporation must proactively execute and file Form IRS 2553 with the Internal Revenue Service to elect Subchapter “S” status. The “S” designation gets its name from Title 26 of the United States Code, Chapter 1, Subchapter S – “Tax Treatment of S Corporations and Their Shareholders.”
If the shareholders elect “S” corporation status, the corporate entity will be considered a pass-through entity and will not be taxed at the corporate level. The only income taxes will be paid at the shareholder level, which eliminates one level of taxation.
While everything else about the two types of corporations are the same, many decisions made by the board of directors and the officers can have significant impact on the taxes paid by the owners depending upon whether the corporation is taxed as a “C” corporation or an “S” corporation. The economic difference between an “S” corporation and a “C” corporation can be a very big deal.