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eturns of its stockholders in proportion to shares of stock owned, regardless of whether those profits
were distributed to the stockholders 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 five tests may, but need not, elect to be taxed as a subchapter S corporation:
1. It must have 100 or fewer stockholders.
2. It may have only one class of stock (although variations in voting rights are acceptable).
3. All stockholders must be individuals (or certain trusts and nonprofits).
4. No stockholder may be a nonresident alien.
5. With certain exceptions, it may not own or be owned by another corporation.
The subchapter S corporation is particularly suited to resolving the problems presented by certain
discrete situations. For example, if a corporation is concerned 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 corporate level, it is
not necessary to establish the right to a compensation deduction. Similarly, if a corporation has
nonemployee stockholders who insist on current distributions of profit, the subchapter S election
would allow declaration of dividends without the worry of double taxation. This would undoubtedly
be attractive to most publicly traded corporations were it not for the 100-stockholder limitation
mentioned earlier.
Many entrepreneurs have turned to the subchapter S election in order to eliminate the two layers of
tax otherwise payable upon sale or dissolution of a corporation. The corporate tax otherwise payable
upon the gain realized on the sale of corporate 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
inception. 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 shelters 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 partnerships. 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 that these profits and losses are passed through to all partners,
including limited partners, even though one could argue that those profits and losses are derived
entirely from the efforts of the general partners. It is this aspect of the limited partnership that made it
the form of choice for tax-sheltered investments. The loss incurred by the business (much of which
was independent of cash flow through depreciation and the like), could be passed through to the
limited partners who, typically, had a considerable amount of other investment and compensation
income to be sheltered.
Although the tax treatments of limited partnerships and subchapter S corporations are similar, there
are some differences that drove the operators of tax shelters to use partnerships over the corporate