What it means
The Internal Revenue Code is a very large body of law, so it is divided into titles, chapters and subchapters. Chapter 1, which covers income taxes, is split into lettered subchapters, each dealing with a topic such as how taxable income is worked out, how partnerships are taxed or how trusts are treated.
A few letters come up in business conversations over and over. Subchapter C governs corporations that pay tax on their own profits, which is why they are called C corporations.
Subchapter S covers small business corporations that pass their income to owners, and Subchapter K covers partnerships. Other subchapters matter to particular entities.
Subchapter J deals with estates and trusts, and Subchapter M deals with regulated investment companies and real estate investment trusts, which can avoid much of the corporate tax if they distribute most of their income. Lawyers and accountants use these letters as shorthand when they discuss structure.
The choice of subchapter affects how many layers of tax the owners face and who reports the profit. A C corporation can be taxed on its profit and then again when it pays dividends to shareholders, while an S corporation or partnership generally passes profit through to the owners to be taxed once at their own level.
The rules, rates and eligibility limits are set by law and change over time, so always check the current text or ask an adviser. Timing matters as well.
An election to be taxed under a different subchapter often has to be made by a deadline, and missing it can mean a year of unwanted tax treatment. Owners who are growing, adding shareholders or planning a sale should review their structure each year with an adviser rather than leaving it unchanged out of habit.
For a non-specialist, the practical point is that an entity's tax treatment is not fixed by its legal form alone. Many entities can choose or elect how they are taxed, which means the label on the registration document and the subchapter that governs the tax return may not match.
In practice
Real-world examples.
Example
A founder forms a company with two partners and wants profits taxed once on their personal returns. Their adviser explains that electing S corporation treatment, under Subchapter S, can do this if the company meets the eligibility rules.
Example
A property business owned by five investors operates as a partnership. Its income, deductions and credits are reported under the partnership rules in Subchapter K and passed through to each partner's return.
Example
A large retailer with thousands of shareholders is taxed as a C corporation. It pays tax on its profit and then shareholders pay tax on any dividends they receive, which is the two-layer outcome that Subchapter C produces. Its finance team accepts this cost because the company needs to retain profits and issue shares to the public.
Case study
Seen in the real world.
Tidewater Design is an illustrative, fictional studio owned by three friends. For its first five years it was taxed as a C corporation, paid tax on its profit, and then the owners paid tax again on the dividends they took out.
When profits reached $600,000 a year, their accountant suggested electing Subchapter S status. The studio met the ownership and shareholder limits, so after the election the profit flowed through to the owners and was taxed once on their personal returns. Their advisers also reviewed the studio's accounts to make sure the election would not disturb its loan agreements.
The change was not free of trade-offs in this illustrative story. The owners now owed tax on profit they had left in the business, so they had to set aside cash each quarter to cover it, and they had to follow rules on how salary and distributions were split.
Watch out
Common mistakes.
- Believing the legal form of a company decides its tax treatment on its own, when the tax election and the rules in the relevant subchapter decide it.
- Assuming every business can choose Subchapter S, when eligibility limits apply to the type and number of owners.
- Treating a subchapter as a rate or a tax, when it is simply the part of the tax code that holds the rules.
Questions
People also ask.
What does C corporation mean?
It means a corporation taxed under Subchapter C as a separate taxpayer, so it pays tax on its own profit.
Does Subchapter K apply to limited liability companies?
A limited liability company with more than one owner is generally taxed as a partnership under those rules unless it elects otherwise.
Why do advisers keep mentioning these letters?
The letters are a quick way to name the set of rules that govern how an entity is taxed.
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