Have you been thinking about whether your business might benefit from being an S Corporation? I presented a webinar for accounting professionals about the S Corp election not too long ago. Within that presentation, I covered information of value to entrepreneurs in all fields. In this article, I will share that insight with you in hopes that it will help you gain a deeper understanding of what it means to be an S Corporation.
What Is an S Corporation?
The S Corporation is not a business structure in itself. Rather, it is a special federal income tax election option for eligible Limited Liability Companies (LLCs) and C Corporations. Business owners must first decide whether to register their company as an LLC or C Corporation before electing S Corporation treatment. The potential advantages of electing S Corporation tax treatment are a bit different for LLCs and C Corps. It’s crucial to consider the differences between the entity types when deciding which one to form to obtain S Corporation status. There are legal and administrative factors to consider in addition to the tax implications.
IRS Eligibility Requirements
Below is an overview of the requirements for the S Corp election. You can find more detailed information about the IRS’s criteria on its website.
A corporation or entity eligible to be treated as a corporation must:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations, or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).
Federal Tax Treatment for C Corporations
The C Corporation is a business entity that is a separate legal and tax-paying entity from its owners (shareholders). It’s the business structure that offers the highest level of personal liability protection to stakeholders. C Corporations may have an unlimited number of shareholders and sell company stock.
Starting and running a C Corporation has more moving parts than other business entity types. There are more legal steps when incorporating and more complex ongoing compliance and tax reporting requirements.
Before discussing S Corp income tax treatment for C Corporations, let’s first review how taxes are normally handled. By default, a C Corp’s profits and losses flow through to the business’s corporate tax return. Taxable income is taxed at the corporate federal income tax rate. Some corporations undergo “double taxation.” This occurs when a corporation pays dividends (which are not tax-deductible for the business) to shareholders. The C Corp pays income tax on those profits, and then the individual shareholders also pay tax on that income on their personal tax returns.
The S Corporation election provides a way to avoid double taxation. How? The corporation’s profits and losses flow through to shareholders’ personal tax returns. The business does not pay corporate income tax.
When S Corporation Election Might Make Sense for a C Corporation
A business’s goals will impact whether the S Corp election is a good fit. I encourage business owners to discuss the pros and cons with their attorney and tax advisor.
Some situations when it might be advantageous for a C Corp to elect S Corp status are:
- When the C Corp’s shareholders want to retain their level of personal liability protection while enjoying the pass-through taxation of the S Corp election.
- If the business owners will rely on the business profits to pay for their daily living expenses.
- If the C Corp shareholders intend to be in the business for a limited time or sell the business in the future.
Again, every business has its own unique circumstances to consider, so it’s helpful to get professional guidance when making decisions related to business entities and tax matters.
Federal Tax Treatment for LLCs
A Limited Liability Company is a separate legal entity from and provides personal liability protection to its owners (members). An LLC may have an unlimited number of members, and its startup and ongoing compliance requirements are not as complex or rigid as those for a C Corporation.
The IRS does not consider the LLC to be its own tax-paying entity. Therefore, by default, all business profits and losses flow through to the LLC members’ personal tax returns. As such, the business’s taxable income is subject to self-employment taxes (Social Security and Medicare) and income tax whether or not the business owners are personally using that money or leaving it in the business. For some LLC members, that tax burden can really add up!
Alternatively, when an eligible LLC elects S Corporation election, only the income paid to LLC members through payroll is subject to Social Security and Medicare taxes (called FICA). Profits paid as distributions to LLC owners are not subject to FICA taxes. This may allow LLC members to lower their personal tax burden. It’s critical that LLC owners realize their company must pay them fair compensation for their work in the business. If they set their pay rate unreasonably low for the work they’re performing to minimize FICA obligations, it could raise a red flag with the IRS. In other words, LLC members shouldn’t try to game the system by taking a suspiciously low wage or salary so that they can take more compensation in distributions.
When S Corporation Election Might Make Sense for LLCs
Some situations when it might be advantageous for an LLC to elect S Corp status are:
- When LLC members want to lower their Social Security and Medicare tax obligations without going through forming and maintaining the compliance tasks of a C Corporation.
- When owners intend to be in the business long-term.
- When LLC members foresee wanting to file taxes as a partnership or sole-proprietor in the future.
I can’t emphasize this enough business owners should consider enlisting legal and tax professionals’ expertise before forming a business entity and making tax elections.
S Corps and State Income Tax
No universal rules exist for how states treat S Corporations. Most states apply pass-through tax treatment to LLCs and C Corporations that have federal S Corp status, others require additional paperwork, and then others do not recognize S Corps at all. Business owners should research their state’s position on how state income tax is handled for S Corporations.
State-Level Requirements
- New Jersey , State-level S Corporation tax treatment requires filing Form CBT-2553. The state will only consider the election valid if all of a corporation’s shareholders consent to the election and other state requirements.
- New York , New York state does not automatically treat a company as a New York S Corporation unless mandated to file as an S Corporation under Tax Law section 660(i). New York requires a corporation to file form CT-6 to apply for S Corporation tax treatment at the state level.
- Arkansas , It was not until 2018 that Arkansas recognized S Corporation tax treatment at the state level without additional paperwork.
- Utah , Utah requires a copy of a company’s Notice of Acceptance as an S Corporation from the IRS. The notice must be attached to Form TC-20S the first time the company files its tax return.
States That Do Not Grant S Corporation Pass-Through Treatment
- District of Columbia
- Louisiana
- New Hampshire
- New York City
- Tennessee
- Texas
- California
States Where It’s a Non-Issue
Some states have no state income taxes at the personal or corporate level, so the pass-through issue is not of consequence. However, keep in mind that some of these states may enforce other types of fees to businesses that elect to be S Corps and their owners.
- Alaska
- Florida
- Nevada
- South Dakota
- Washington
- Wyoming
How to Become an S Corporation
C Corporations and LLCs use the same process when filing for S Corporation treatment. They complete and file IRS Form 2553 (Election by a Small Business Corporation). Review my past blog post about Form 2553 for additional information.
The election must be made no more than two months and 15 days after the beginning of the tax year when the election goes into effect. Newly formed LLCs and C Corporations have two months and 15 days (75 days) from their date of formation to file for S Corporation election. If a Corporation or LLC fails to timely file its IRS form 2553 with the IRS, the S Corporation election will NOT be effective for that tax year. The result:
- A corporation will be taxed as a C Corporation.
- A single-member LLC will be taxed as a sole proprietorship
- A multi-member LLC will be taxed as a partnership.
Generally, a late S Corporation election is effective for the next tax year. Relief for late election may be available if the C Corporation or LLC can show that the failure to file on time was due to reasonable cause. Business owners can request a six-month extension to file for S Corporation status by filing IRS Form 7004.
Operating as an S Corporation
How an S Corporation’s Owners Get Paid
It’s important to understand how S Corp business owners pay themselves. Handling compensation properly will help avoid red flags with tax authorities.
- An S Corporation owner (either C Corp shareholder or LLC member) who does substantial work for the S Corp is considered an employee of the corporation and must take a reasonable salary from the corporation on the payroll.
- The business must put the owner on payroll and compensate them through a reasonable salary – from which payroll taxes are withheld.
- An S Corporation’s remaining profits are paid out in the form of distributions to the company’s shareholders, who report those distributions on their personal tax returns.
- S Corporation owners can run into trouble if they pay themselves a suspiciously small salary and then take most of their compensation in the form of distributions to minimize the amount of taxes they have to pay. The IRS can revoke an S Corporation status if they determine shareholders are substantially underpaid for the services they provide.
Ongoing Compliance Requirements
Here’s a general idea of what business owners might expect regarding the initial filing and annual compliance requirements for LLCs, C Corporations, and S Corporations. Note that individual state requirements vary.
LLC Initial Filing Requirements
- Initial Filing (some states)
- Initial Report (some states)
- Publication Fees (some states)
LLC Annual Compliance Requirements
- Annual Reports
- Maintaining a Registered Agent
C Corporation Initial Filing Requirements
- Initial Filing (some states)
- Initial Report (some states)
- Publication Fees (some states)
C Corporation Annual Compliance Requirements
- Annual Reports
- Annual Meetings
- Meeting Minutes
- Maintaining a Registered Agent
S Corporation Initial Filing and Compliance Requirements
An S Corporation’s initial filing and annual compliance requirements are the same as those for the underlying entity type. In other words, the filings and compliance obligations of the LLC or C Corporation that elected S Corp tax treatment remain in place for the business.
Resources for Learning More
You can learn more about the S Corporation election by watching my webinar. Also, visit the CorXec website for more information about business formation and compliance filings. I’ve provided some direct links to various guides and tools below.
- Choosing a Business Structure
- Business Structure Wizard
- Benefits of Incorporating a Business
- Advantages and Disadvantages of a Subchapter S Corporation
- Starting a Business Checklist
- Incorporate a Business
- Form an LLC
- Federal Tax ID Number
- Business Filings
- Registered Agent Services
Let CorXec Help
My team is here to assist you with all of your business formation and compliance filing needs. Also, we offer the CorXec Partner Program to accountants, lawyers, tax preparers, bookkeepers, and other professionals who wish to expand their revenue streams by offering CorXec’s services on a resale or referral basis to their business clients.
References:
Internal Revenue Service. “S Corporations.” IRS.gov, Updated 2021. Accessed 26 February 2021.
