Is an S Corporation Election Right for Your Business?
March 8, 2021
When a corporation is formed, it is taxed as a “C Corporation.” All corporations are separate legal entities from their shareholders and have their own taxpayer identification number (an employer identification number or EIN). Corporations file separate income tax returns and pay corporate income tax on their income. If the C Corporation distributes any money to its shareholders as a dividend, it distributes after tax dollars. The shareholders then pay tax again on those distributions, essentially resulting in double taxation of the C Corporation’s income.
Other types of legal entities are taxed differently. Partnerships (both general and limited) and limited liability companies are taxed as pass through-entities. The entity will file an information return, but does not pay any income taxes on the entity level. Instead, the profits and losses are passed through to the partners or members, who pay tax on their pro-rata share at their individual tax rates. Corporations can receive the same pass-through treatment by filing a Subchapter S Corporation Election.
What is an S Corporation?
The definition of an “S Corporation” is a corporation that is treated, for federal (and state) tax purposes, as a pass-through entity. An S Corporation is created through the filing of an election made with the Internal Revenue Service (IRS) to be considered an S corporation. S corporations are taxed under Subchapter S of the Internal Revenue Code (IRC), which is where their name is derived. Like a sole proprietorship or a partnership, an S corporation passes through most of its income and loss items to its shareholders. Unlike a regular, C Corporation, there is no “double taxation,” meaning that the owners do not need to pay taxes twice – once at the corporate level and again on the individual shareholder level. Each shareholder is subject to his or her own individual tax rate on the profits and losses passed through to him or her, recorded as net income on the income tax return.
S Corporation Benefits for LLCs
LLC members pay income tax and self-employment taxes on all of the business’s profits. If the LLC elects to become an S Corporation, the members would only have to pay self-employment taxes on the portion that was paid as salary through payroll. Profit distributions would not be subject to Medicare and Social Security taxes, so the LLC members’ individual tax burdens may be lowered. It is important to note that the salary one pays must be reasonable for the type of position and industry involved. If the IRS determines that the salary was not reasonable, additional taxes, penalties and interest may be imposed.
S Corporation Benefits for C Corporations
A C Corporation pays tax on its profits at the corporate tax rate. If corporate income is distributed as dividends, the shareholders report and pay tax on their personal returns, effectively being “double taxed. (Dividends are not tax-deductible). With an S Corporation election, the Corporation’s profits and losses flow through the shareholders’ personal tax returns. No income taxes are paid at the corporate level. As with LLCs, shareholders would only have to pay self-employment taxes on what was paid as salary through payroll. Profit distributions would not be subject to Medicare and Social Security taxes, potentially lowering individual tax burdens.
Who cannot choose an S Corporation elective?
Sole proprietorships and partnerships are not eligible to elect S Corporation status and would have to form an LLC or incorporate to do so. There are also restrictions as to number and types of shareholders and classes of stock.
What are the criteria for an S Corporation?
To be taxed as an S Corporation, a corporation or LLC must meet all IRS requirements, have consensus of all shareholders or members, use a permitted tax year, and must file IRS Form 2553. The qualifying requirements are:
- It must be a domestic corporation that is either organized in the United States or organized under federal or state law. The term ‘‘corporation’’ includes joint-stock companies, insurance companies, and associations. Limited liability companies can also elect S Corporation status;
- It must have only one class of stock;
- It must have no more than 100 shareholders;
- It must have as shareholders only individuals, estates (including estates of individuals in bankruptcy), and certain trusts. Partnerships and corporations cannot be shareholders in an S Corporation; and
- All shareholders must be United States Citizens or resident aliens. It must have no nonresident alien shareholders.
- Profits and losses are passed through to the Shareholders on a pro-rata basis according to their ownership interest. This cannot be modified. If the S Corporation wants to make a distribution to one shareholder, it must make distributions to all shareholders on a pro-rata basis or risk losing its Subchapter S status.
The form 2553 can be filed any time during the previous tax year for the next tax year or by the 15th day of the third month of the current tax year to which the election will apply.
If you are interested in learning if an S Corporation election is right for your business, contact us online or call (412) 338-1100.