In a recent post we discussed the pros and cons of various legal structures (sole proprietorships, partnerships, LLCs, and corporations) and we mentioned that in certain situations business owners can elect to be taxed as a “S-Corporation.” In this week’s post we will explore the S-Election in a bit more depth.
What is a S-Corporation
An “S-Corporation” is not a separate type of corporation. Rather, it is a tax classification that certain businesses can elect with the IRS by filing form 2553.
S-Corp taxation allows a corporation to preserve the limited liability granted to a corporation’s shareholders while allowing the corporation and its owners to pay income taxes as though the corporation were operating as a partnership (for two or more individuals) or as a sole proprietor (for individuals).
As a result, corporations taxed as a S-Corporation will generally have a more favorable tax treatment. This is because regular corporations (often called C-Corporations) are taxed twice: once at the corporate level when the corporation pays taxes on its income and once at the individual level when the shareholders pay taxes on dividends.
However, in S-Corporations, all of a company’s income is “passed-through” to the shareholders. The shareholders then report that income on their personal tax returns. As a result, the corporation itself avoids paying income taxes.
Before a corporation can elect S-Corp status, it must be sure it complies with the strict rules in place by the IRS. And perhaps more importantly, the corporation should put procedures in place (such as rules in bylaws) to prevent the company from losing the election or it may face large tax liabilities.
According to the IRS, “to qualify for S-Corporation status, corporations must meet the following requirements:
1. Be a domestic corporation
2. Have only allowable shareholders (including individuals, certain trusts, and estates and may not include partnerships, corporations or non-resident alien shareholders)
3. Have no more than 100 shareholders
4. Have only one class of stock, although having stock which cannot vote or has limited voting rights does not constitute a second class of stock so long as it has equal rights to dividends, distributions, and the assets of the company.
5. Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).”
LLCs Taxed as S-Corps
Although the above contemplates corporations electing S-Corp status, keep in mind that LLCs can also elect this status if they meet the above requirements. However, rather than making the S-Election to get pass- through taxation, LLCs most often make this election to save money on self-employment taxes.
Should You Elect S Corporation Status?
Before electing (or terminating) S-Corporation status, you should almost always speak to a business attorney for advice. However, we can offer a couple tips in this post!
First, if you have significant income from other businesses, electing S-Corp status may allow you to pass through losses to your personal returns to offset some of your other income.
Second, if the company has significant profits, you may be able to have the corporation pay you a reasonable salary, which increases bookkeeping expenses, and then distribute remaining profits as shareholder distributions (the equivalent of dividends), on which only income tax is paid, which saves the amount of social security taxes, unemployment taxes and other employment related taxes imposed on wages. It is very important to discuss with your attorney and accountant what constitutes a reasonable salary.
Third, for LLCs, if you elect to be taxed as a corporation by filing form 8832 (Entity Election) and then elect S corporation status by filing form 2553, distributions of profits are not subject to self-employment taxes (which are about 15%). Rather, only wages paid to shareholder-employees are subject to such taxes. However, the same issues as to what constitutes a reasonable wage must be considered.
What Should Your Business Do?
This can be a tough question and every situation has its own set of circumstances. For that reason, we recommend you contact one of our experienced business attorneys to discuss whether a S-Election is appropriate for your situation.
*This article is very general in nature and does not constitute legal advice. Readers with legal questions should consult with an attorney prior to making any legal decisions.