What is an S-Corp?
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An S-corp is a tax designation granted by the IRS that can be advantageous for some businesses. If you elect to be an S-corp, your company will be taxed differently and will be required to meet and maintain certain requirements.
To apply for the S-corp election, you must meet eligibility requirements and submit Form 2553 to the IRS.
S-Corp Election For LLCs & Corporations
What is an S-Corporation?
“S-corporation” is a tax status given by the IRS. Business entities, like LLCs or corporations, start out with a “default” tax status. For instance, by default, corporations are taxed as C-corps and multi-member LLCs are taxed as partnerships. However, these business entities can choose to be taxed differently if it makes sense for their business. Both LLCs and corporations can choose to be taxed as S-corps if they meet eligibility requirements.
In a nutshell, the S-corp tax election combines some aspects of the partnership and C-corp tax statuses.
- Like partnerships, S-corps receive pass-through taxation. In other words, the business itself doesn’t pay a federal corporate income tax. Instead, income “passes through” to the shareholders who report the income on their individual returns.
- Like C-corps, S-corps can make distributions, which aren’t subject to employment taxes. (Note that compensation is still subject to employment taxes. S-corps are required to pay a reasonable salary to those who provide services to the business.)
Common Misconceptions about S-Corps
There are a lot of myths and misconceptions surrounding the S-corp election. Some of the most glaring misunderstandings are below:
MYTH: S-Corps are Business Entities.
An S-corp is not an actual entity type. It’s simply a tax status granted by the IRS. So, if an LLC applies to be taxed as an S-corp, it’s still an LLC. The LLC will just be taxed differently by the IRS.
MYTH: Only Corporations Can Be S-Corps.
Corporations can choose the S-corp election—but so can LLCs.
MYTH: S-Corps Automatically Save You 15% on Your Taxes.
There’s a reason this sounds too good to be true. The “15%” is roughly the combined rate for self-employment taxes (social security and Medicare). While it’s true that S-corps can make distributions (which aren’t subject to these taxes), your business still has to pay reasonable compensation to those who provide services as well. So at best, the 15% “savings” only applies to a portion of business income.
MYTH: All LLCs and Corporations Should Make the S-Corp Election.
Nope. Electing to be taxed as an S-corp can save some businesses money, but any savings depends on a number of factors, including your business income, salaries, deductions, and whether or not you plan to keep money in your business or make distributions.
What are the IRS Restrictions for S-Corps?
The IRS has specific requirements for corporations and LLCs who wish to make the S-corp election. To apply for S-corp status, your company must meet all of the following:
- Be a Domestic Entity
- Have Allowable Shareholders/Members
- Have No More Than 100 Shareholders/Members
- Have Only One Class of Stock
- Not Be an Ineligible Entity (such as DISCs or certain banking or insurance companies)
S-Corp Benefits for LLCs
The S-corp election is a common choice for LLCs, largely due to the potential for savings on self-employment taxes. If your LLC is taxed as a partnership or disregarded entity, all the income your business makes is considered self-employment income and is subject to self-employment taxes (15.3%).
However, if you declare your company as an S-corp, you can divide your profits between payroll and dividends. You’re required to pay a reasonable wage to those who provide services to the business. If you have leftover profit, you can pull that down to yourself as personal income as a dividend. Whatever profit you take as a dividend isn’t subject to self-employment taxes.
So, imagine you run your LLC yourself and end up with $40,000 net taxable income at the end of the year. With an S-corp election, you divvy up the profit, paying yourself $25,000 for the year and taking a $15,000 dividend—thus saving 15.3% of $15,000 dollars.
If you’re bringing in a lot of income, tax savings with an S-corp can be substantial. However, if you’re not yet making enough money to cover salaries and the expenses of setting up payroll, an S-corp election might not be the best choice—at least at the moment. You can always change your tax status later on when your business is making a steady profit. For a detailed comparison, see our S-corp vs LLC page.
S-Corp Benefits for Corporations
Corporations who intend to make a lot of distributions—as opposed to reinvesting money in the business—may benefit from an S-corp election. With default (C-corp) status, the corporation itself pays taxes on income. Then, if you ever decide to take a dividend, you’ll also have to report that income on your personal return—meaning profits are essentially taxed twice.
S-corps, however, receive pass-through taxation. This means that income isn’t taxed at the entity-level. Instead, shareholders pay the personal tax rate for their percentage of profits—so no “double taxation.”
While avoiding double-taxation can lead to substantial tax savings, note that S-corps have a smaller pool of available tax deductions than C-corps. For instance, C-corps can often deduct employee insurance benefits. Additionally, the limit of one class of stock can make raising capital more difficult, as can the restrictions on who can be S-corp shareholders.
How Do I Become an S-Corp?
While you don’t technically “become” an S-corp, you can elect to be taxed as an S-corp by filing Form 2553 with the IRS. Some states require businesses to alert them of their S-corp status. In New Jersey, for example, S-corp businesses must also file Form CBT-2553 with the NJ Division of Revenue and Enterprise Services.
If you want to make the election for the following tax year, you can file any time. If you want to make the election for the current year, you must apply within the first 2 months and 15 days of the tax year.
Late S-Corp Election Relief
Yes, in some cases. The IRS allows relief for late elections when a corporation or LLC proves that their late filing was due to “reasonable cause.” A reasonable cause can include a clerical error, or in some cases it might be that your CPA or CEO neglected to file for S-corp status or didn’t know about the IRS deadline—ultimately, the IRS will determine if your cause is “reasonable.”
When submitting documents for late S-corp election, you must still submit Form 2553 to the IRS. However, in the top margin of the first page, you must include the phrase: “FILED PURSUANT TO REV. PROC. 2013-30.” If you are filing for late S-corp election after the fiscal year, you should attach Form 2553 to your S-corp income tax return (Form 1120-S) and in the top margin of the first page, write: “INCLUDES LATE ELECTION(S) FILED PURSUANT TO REV. PROC. 2013-30.” Rev. Proc. 2013-30 is the section of the US tax code that allows for late filings.
You will also need to state the reason for your late S-corp election (Box “I”), and obtain consent and signatures from your shareholders (Boxes “J” – “N”).
Forming a new LLC or corporation? We can form your business and file your S-corp election for you at the same time for an additional $50.