S Corporation and Taxes: Everything You Need to Know
S corporation and taxes refers to how one will be taxed if their business entity is treated as an S corporation by the IRS. 3 min read
2. S Corporation Taxation
3. Additional S Corporation Taxes
4. S Corporation Election for LLCs
5. State Taxes for S Corporations
6. Additional S Corporation Costs
7. Electing S Corporation Status
S Corporation and Taxes
S corporation and taxes refers to how one will be taxed if their business entity is treated as an S corporation by the IRS. Being an S corporation means that one is electing to be taxed at the shareholder level rather than the corporate level, which is the level that C corporations are taxed at.
S Corporation Taxation
With the S corporation election, taxes are passed through to the shareholders, even though the S corporation must still make a tax filing with the IRS. These pass-through taxes are then divided amongst the shareholders proportional to their investment. Doing this allows shareholders and owners to avoid double taxation where they are taxed at both the corporate and personal level. This is the main defining characteristic of S corporations insofar as taxes are concerned.
Additional S Corporation Taxes
Although S corporations do not have double taxation, there are some taxes they must pay at the corporate level, such as:
- Excessive net passive income tax. This is a tax on passive S corporation income. It only applies if an S corp underwent a tax-free reorganization with a C corp or if the S corp used to be a C corp. Passive income can include that which comes from dividends, interest, annuities, royalties, and rents.
- LIFO recapture tax. “LIFO” stands for “last in, first out,” which is an inventory measuring method for taxation purposes. The LIFO tax will be incurred if your corporation used LIFO inventory pricing in the previous year or if a C corp transferred LIFO inventory to you as property in a non-recognition transaction.
- Built-in gains tax. This applies if an S corp unloads an asset within five years of getting that asset and the asset was acquired when the S corp was a C corp or the asset was acquired from a C corp tax free.
S Corporation Election for LLCs
Although corporations electing the S status benefit insofar as taxes are concerned, they are still treated like corporations in all other respects. Thus, there will be more paperwork, legal obligations, and structural requirements—duties that smaller businesses may want to avoid. If such is the case, running an LLC with an S corporation tax election is another option.
LLCs with S corporation tax election retain the benefits of the LLC structure and obtain the benefits of S corporation taxation, while at the same time avoiding the S corporation structural and legal requirements, such as holding formal meetings and keeping minutes of those meetings.
Another advantage of this approach is that you can divide the LLC’s earnings into salaries, which can then be turned into passive income as distributions. Such distributions are not subject to FICA tax (Medicare and Social Security), while salaries are.
State Taxes for S Corporations
Taxation for S corporations on the state level varies from state to state. Taxation in some states is similar to that of federal income tax where each shareholder is taxed for their share of S corporation income. Other states levy taxes on the S corporation directly. For example, in Illinois the S corporation tax is 1.5% of the S corporation’s income, and this is an additional tax on what the shareholders will pay for their S corporation income.
Additional S Corporation Costs
Although S corporations will allow you to save on your taxes, there may be other costs that could outweigh the savings. For instance, if you are running a corporation with S status election, there will be both start-up and ongoing accounting and legal costs, especially for larger corporations. Or there could be additional taxes that you have to pay. In California, for example, S corps must pay a 1.5% tax on their income and the minimum payment must be $800.
Electing S Corporation Status
If you believe electing the S corp status will be best for your business, you will first have to make sure that the following are true of your business:
- It has only one type of stock.
- It has 100 shareholders or less.
- Its shareholders are US residents and not partnerships, other corporations, or other unpermitted entities.
If such is the case, you must then submit Form 2553 to the IRS. Doing so is time sensitive, as the paperwork must be filed within two months and fifteen days of the start of the tax year.
If you need help understanding issues related to S corporation and taxes, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.