Is S Corporation Election Right for My Business? It Depends on Your Business Structure
You’ve probably heard that being an S Corporation has some perks. It certainly can for some businesses. Might it be the right option for you? Let’s take a moment to chat about all things S Corp so that you can gain a better understanding of what it is and its potential advantages.
First, an S Corp isn’t a type of business entity; it’s a special tax election that an eligible limited liability company (LLC) or corporation may choose. In other words, business owners must decide whether their company will form as an LLC or a corporation before they elect for S Corporation tax treatment.
The potential advantages of electing for S Corp tax treatment are a bit different for LLCs and corporations. It’s crucial to consider those differences when deciding whether it’s best to form a company as an LLC or corporation to obtain S Corporation status. It’s also critical you understand the differences between the LLC and corporation business entity types. Aside from the tax implications, there are also legal and administrative factors to consider.
Let’s step through the basics of each business structure and explore how choosing S Corporation election affects each:
Corporation Business Structure
A corporation (often called a C Corporation) is a separate legal and tax-paying entity from business owners. It exists and dies independently of its owners. This business structure provides business owners (shareholders) the highest degree of protection against any debt and legal liabilities of the company.
A C Corporation may sell shares of company stock, have an unlimited number of shareholders, and offer its employees a stock option plan.
Starting and running a Corporation
Incorporating and operating a business as a corporation is more involved and usually more costly than forming an LLC. Several of the legal steps involved include:
- Selecting a board of directors
- Drafting corporate bylaws
- Formally registering the business by filing Articles of Incorporation with the state
- Obtaining an Employer Identification Number (EIN) from the IRS
- Applying for all applicable business licenses and permits
- Issuing stock certificates
- Complying with all ongoing legal and tax requirements (such as submitting annual reports, holding board of directors meetings, holding shareholder meetings, keeping detailed meeting minutes, and more)
Default tax treatment of Corporations
A C Corporation’s profits and losses flow through to a corporate tax return. Taxable income (income after allowed business deductions) is taxed at the corporate tax rate. Note that some business income undergoes what many call “double taxation.” Business profits paid as dividends to shareholders are not tax-deductible for the business, so the corporation pays taxes on those dollars, and then the shareholders pay income tax on them, as well.
S Corporation tax treatment for Corporations
S Corp election may benefit some corporations because it allows them to avoid double taxation. With S Corporation status, the corporation’s profits and losses flow through to shareholders’ personal tax returns; the corporation itself does not pay income tax. So, the corporation’s profits are taxed at the shareholder level (according to their share of ownership) at the applicable individual tax rates. Shareholders that are also employees of the corporation only pay self-employment tax on the wages or salary that the corporation pays them. Dividend income paid to shareholders is not subject to self-employment (Medicare and Social Security taxes).
Note that corporations that want to maximize their growth potential may find the S Corp option limiting; S Corps may not have more than 100 shareholders.
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Limited Liability Company (LLC) Business Structure
The LLC structure offers liability protection for business owners (members) with less rigid compliance requirements than a C Corporation. An LLC is considered a separate legal entity from its owners, so under most circumstances owners are not personally responsible for the debts of the company.
Starting and running an LLC
Several tasks involved in forming an LLC include:
- Filing Articles of Organization with the state
- Obtaining an EIN from the IRS
- Applying for the necessary licenses and permits
- Complying with ongoing business compliance responsibilities, such as maintaining a registered agent, filing annual reports, keeping business finances separate from owners’ accounts, and more
Default tax treatment of LLCs
Although the LLC protects its members from legal and financial liabilities, it is not considered by the IRS to be a separate tax-paying entity. An LLC is a “pass-through entity,” similar to a partnership or sole proprietorship. Profits and losses flow through to the LLC members’ personal tax returns and get taxed at the applicable individual income tax rates. Not only are the LLC’s profits subject to income tax, but its taxable income is also subject to self-employment taxes. For some LLC owners, that could result in a rather hefty personal tax burden.
S Corporation tax treatment for LLCs
S Corp tax treatment can help LLC members reduce their self-employment tax burden. The individual income tax rate applies to all taxable business income as before, but not all of that income is subject to self-employment taxes. LLC members who are on the company payroll will only pay self-employment taxes on the income they receive as salary or wages. The rest of their income—paid as distributions—is not subject to self-employment taxes.
Keep in mind that the salary that the LLC pays its owners must be fair compensation for the work performed. If an LLC pays its members unreasonably low wages so that members can take the majority of money as distributions, it could raise red flags with the IRS and other tax authorities.
How to Become an S Corporation
IRS eligibility requirements to become an S Corp include:
- You must have an LLC, partnership, or C Corp already in place
- Your entity must be domestic
- Your company must have 100 or fewer shareholders
- Your shareholders may not be non-resident alien shareholders, partnerships, or corporations
- Your corporation may only have one class of stock (you are allowed to have voting and non-voting as one class)
A corporation must file Form 2553 (Election by a Small Business Corporation). An LLC must file to be taxed as a corporation first before it can elect S Corporation status. If a new LLC files Form 2553 promptly, the IRS will typically consider that as sufficient notice that the LLC wants corporate tax treatment. If a new LLC waits around to submit Form 2553 or an existing LLC wishes to elect for S Corp status, then the LLC must file Form 8832 (Entity Classification Election) first and then Form 2553.
2020 Deadlines for S Corporation Election
For S Corp tax treatment to be in effect for 2020, existing businesses must meet the IRS deadline of March 16, 2020 to file Form 2553. Missing the deadline means the business will continue to be taxed as a C Corp or LLC for the remainder of the 2020 tax year, with S Corp treatment kicking in on January 1, 2021.
Newly formed LLCs and corporations have two months and 15 days (75 days) from their date of formation to file for S Corporation election for the tax year 2020. Note that business owners can request a six-month extension to file for S Corp status by filing IRS Form 7004 (Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns).
Look and Learn Before You Leap
Often, entrepreneurs will start off as an LLC because of its simplicity and flexibility. Then, as their business grows, they opt to elect S Corp status. Rather than converting to a corporation and then electing S status, it is simpler to “check the box” and elect to file an LLC as an S corporation. Business owners may opt to convert back to an LLC at a later date if they choose.
If business owners discover that S Corp status is not as advantageous as they thought it would be, the company can revoke the status at any time through a majority shareholder vote. The company can set its own revocation date and, if that date happens sometime during the tax year (rather than at the end of the tax year), two separate tax returns must be filed—one as an S Corp and the other as the LLC or C Corp.
Before moving ahead with choosing a business structure or type of tax treatment, take the time to understand the pros and cons of the available options. Your decision will affect you legally and financially, so consider doing more research and talking with licensed legal, tax, and accounting professionals for guidance.
RELATED: 6 Business-Boosting Benefits of Incorporating Your Company
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