Electing to be an S Corporation

An S Corporation (S Corp) is a special tax designation that allows businesses to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Here’s how to become an S Corporation and the associated requirements:

Steps to Become an S Corporation

1. Form a Corporation or LLC:

  • Start by creating a legal business entity. You must form either:
    • A C Corporation by filing Articles of Incorporation with your state, or
    • An LLC, which can later elect S Corp status.

2. Meet Eligibility Requirements: To qualify as an S Corporation, your business must:

  • Be a domestic corporation or LLC.
  • Have no more than 100 shareholders.
  • Have shareholders who are individuals, certain trusts, or estates (not partnerships, corporations, or non-resident aliens).
  • Have only one class of stock.
  • Not be an ineligible corporation (e.g., certain financial institutions, insurance companies).

3. File IRS Form 2553:

  • Submit Form 2553: Election by a Small Business Corporation to the IRS to elect S Corp status.
  • Deadlines:
    • If you’re a newly formed business, file Form 2553 within 2 months and 15 days of starting your business.
    • For existing businesses, file by March 15 to be treated as an S Corporation for the current tax year.

4. Maintain Ongoing Compliance:

  • Ensure you meet S Corp requirements every year, including limits on shareholders and stock.
  • File annual reports or franchise taxes as required by your state.

Advantages of an S Corporation

Key Tax Savings of an S Corporation

1. Avoidance of Double Taxation:

  • Unlike a C Corporation, which pays corporate taxes and then taxes shareholders on dividends, an S Corp is a pass-through entity. This means:
    • Income is taxed only at the shareholder level, avoiding corporate- level taxation.

2. Reduction in Self-Employment Taxes:

  • In a sole proprietorship or partnership, all business profits are subject to self-employment tax (Social Security and Medicare), which is 15.3%.
  • In an S Corp:
    • Shareholders who work in the business are considered employees and must pay themselves a reasonable salary.
    • The salary is subject to payroll taxes (Social Security and Medicare).
    • Remaining business profits (distributed as dividends) are not subject to payroll taxes.
  • Example:
    • Business profit: $100,000.
    • Reasonable salary: $50,000 (subject to 15.3% payroll tax = $7,650).
    • Distribution: $50,000 (not subject to payroll taxes).
    • Total self-employment tax: $7,650 vs. $15,300 if the entire profit were taxed as self-employment income.

3. Pass-Through Taxation:

  • Profits, losses, deductions, and credits pass through to shareholders, who report them on their personal tax returns.
  • This can lower overall taxable income if shareholders can use losses to offset other personal income.

4. Qualified Business Income Deduction (QBID):

  • S Corp owners may qualify for the 20% Qualified Business Income Deduction under Section 199A.
  • This allows a deduction of up to 20% of the business’s net income, further reducing taxable income.

5. Flexibility in Income Distribution:

  • The ability to split income between salary and distributions allows for tax planning.
  • Shareholders can adjust salaries to optimize tax savings, as long as salaries are “reasonable.”

Limitations and Considerations

1. Reasonable Salary Requirement:

  • The IRS requires that shareholder-employees be paid a reasonable salary for their work. Underpaying yourself to minimize payroll taxes can trigger audits and penalties.

2. State Taxes:

  • Some states do not recognize S Corps and tax them as C Corps or apply additional taxes (e.g., franchise taxes or minimum fees).

3. Compliance Costs:

  • Maintaining an S Corp involves additional administrative and compliance costs, including payroll services and accounting fees.

4. Profit Levels:

  • The tax savings of an S Corp are most beneficial for businesses with profits that exceed a reasonable salary for the owners. If profits are low, the additional administrative costs may outweigh the savings.

When Does an S Corporation Save Taxes?

  • An S Corp is most advantageous when:
    • The business is profitable.
    • A reasonable portion of profits can be distributed as dividends rather than salary.
    • The owner’s salary is optimized for payroll tax savings.