More than a few people prefer to form corporations to protect their businesses, but look for a more favorable tax situation. The answer, of course, is the S-corporation.

For a long time, corporations were the dominant business entity available to most business. With their rigid rules protecting shareholders from personal liability for the debts of the business, they were a smart and popular choice. The downside of the corporate entity, however, had to do with taxes. Simply put, a double taxation situation arose because the corporation had to pay taxes on its profits and then the shareholders had to also pay taxes on their dividends and earnings.

The IRS eventually got around to dealing with the double taxation issue. Well, Congress did. Instead of changing how the corporation was taxed, Congress enacted Subchapter S of the internal revenue code. This section, of course, lends its title to the name of the “S” corporation.

The goal with the new tax code section was to give small business a break when they used corporations. Instead of dealing with double taxation issues, small businesses could elect to be treated differently. By electing to be an S-corporation, they could pass through the finances of the business to their personal tax returns much like a partnership. This is not a tax article per se, so the important thing to understand is the tax burden is less with the S election.

In passing the code, Congress also limited the situations in which it could be used. The restrictions are fairly basic. You can have no more than 75 shareholders. The shareholders can be individuals, but not LLCs or C corporations. Congress also required you to show your cards early on your designation. You have 2 months and 15 days from formation to declare your S status by filing form 2553 with the IRS.

You will note from the above discussion, there is no mention of states. This is because the S corporation is purely a federal tax issue. Many states do not even recognize that S corps exist for tax purposes, meaning they tax it exactly like a C corporation. Obviously, you will have to check your states view on the matter.

Regardless, the important thing to tax from this article is the S-corporation is largely a tax issue on the federal level. When it comes to forming the entity in your state, you just file the basic corporation papers required by your secretary of state. The S election is then made with the IRS.