S Corporation Election: Everything You Need to Know
An S Corporation, also known as an S Corp, is a specific type of corporation that is created by filing and IRS tax election. 5 min read
What Is an S Corporation Election?
An S Corporation, also known as an S Corp, is a specific type of corporation that is created by filing and IRS tax election. This allows those that are able to avoid double taxation while protecting the owner from liability.
S Corps are the most common type of corporation. About 70 percent of all corporations are an S Corp.
S Corporation Requirements
There are many requirements that a company needs to meet to file as an S Corporation.
- The corporation can't have more than 75 shareholders. When counting the 75-shareholder limit, a husband and wife count as one. Only individuals, estates, certain trusts, certain partnerships, tax-exempt charity groups, and other S Corporations count as shareholders.
- The corporation must be U.S. based. There cannot be any investors from other countries.
- You cannot have issued more than one class of stock. If you have already issued both common and preferred stock, you are not eligible for S Corporation elections.
- December 31 must be your year-end.
- You need to make the S Corporation election no later than two months and 15 days after the first day of your taxable year.
- All shareholders need to agree to the S Corp election.
How to Make an S Corporation Election
Once you make sure that you meet all the needs to have an S Corporation election, you need to send in a completed Form i2553 (Election by a Small Business Corporation). All the shareholders must sign.
The deadline for electing your company for S Corporation tax treatment will depend on when you incorporated. A corporation or LLC needs to file an S Corporation election within the first two months and 15 days of the time of starting. If you make this deadline, you will be able to hold S Corp status for your first tax year.
If your business has been incorporated for a few years, you can file the election at any time from the first day of your tax year until two months and 15 days after that date. You will then hold S Corp status for the next tax year.
Advantages of S Corporation Election
There's a reason more than half of the businesses in the United States have become S Corporations. The advantages of an S Corporation election are many:
- You only need one person to form an S Corporation. In some states, you need at least two people to form an LLC.
- An S Corporation always exists. Unlike LLCs that usually have limited lifespans.
- You are free to give away your stock in S Corporations. This means that the shareholders of S Corporations are able to sell their interest without having to get the approval of the other shareholders.
- In terms of self-employment taxes in comparison to LLCs, S Corporations are helpful.
- S Corporation elections protect owners from any liability, lawsuits, or responsibility for the corporation's debt.
- While owners of single proprietorships and partnerships need to pay self-employment tax, S Corporations have their profits reduced by the amount paid to owners as employees. Their total self-employment tax bill is much lower.
- S Corporations do not pay double tax. A regular corporation pays income tax on its profits and has its owners taxed on the dividends they receive. In an S Corporation, the corporation doesn't pay income tax. Instead, the owners pay income taxes based on their shares of the profits. This is known as "pass-through" tax.
- If an S Corporation makes a loss, each of the owner's shares of that loss is "passed through" to their income tax returns. If the owners have any other income, the loss reduces that part of their income and they pay less tax overall.
Disadvantages of S Corporation Election
Despite all the advantages of electing an S Corporation, there are still a few disadvantages to filing as an S Corporation:
- S Corporations need to follow the rules of all other corporations, meaning higher legal and tax service fees.
- There is a lot more paperwork for an S Corporation than for an LLC. You need to file articles of incorporation, hold director and shareholder meetings, keep a record of all corporate minutes, and let shareholders vote on all major decisions.
- S Corporations are only allowed to issue common stock, which can cause problems when trying to raise capital.
- S Corporations are not allowed to file for an initial public offering.
Selling Assets During the Recognition Period
The recognition period of a company is the time after they first file as an S Corporation. It is usually 10 years. During this 10-year period, if an S Corporation sells or distributes any of their assets, they will be subject to the highest corporate income tax rate. This was put in place to stop corporations with assets that have gained in value from electing S Corporation status to distribute their assets and avoid paying large tax amounts.
Combining the Benefits of the LLC and S Corporation
There are a few benefits to remaining an LLC and filing as an S Corporation in the eyes of the IRS:
- Remaining an LLC means much less admin work than becoming a corporation. There is fewer filings, forms to fill out, startup costs, not as many formal meetings, and minimal record-keeping needs.
- Your business will be treated as an S Corporation for tax purposes. You will receive the pass-through tax benefits.
- In the eyes of the IRS, your company will exist separately from you and the other owners. The company will pay wages to you or other owners. That amount will be subject to the Federal Insurance Contributions Act (FICA) tax, but the remaining net earnings can be given to you and the other owners as passive dividend income, which is not subject to income tax.
Advantages of an LLC
An LLC is a business structure that varies by state. They are governed by state statutes of the state that they register through. LLCs are designed to provide the limited liability of a corporation, but the tax benefits and flexible operating of a sole proprietorship or general partnership.
- It is eligible for pass-through taxation, unless you choose to be taxed as a corporation. This means that all of an LLC's profits and losses pass through the LLC to its owners, which are called members. Just like a proprietorship or partnership, each member reports the profits and losses on his or her federal tax return. This avoids the double taxation that corporations are subject to.
- LLCs provides a limit on the personal liability of its members in the same way a corporation does. A member's personal liability is limited to their original investment. This distinguishes an LLC from a sole proprietorship or general partnership, where each owner is liable for all of the debts of the business.
- LLCs have much easier operating requirements. They have fewer filings, fewer forms to fill out, fewer start-up costs, fewer formal meetings are required, and fewer records to keep.
- There are fewer profit-sharing restrictions. All of the earnings are distributed to the members as they see fit. It is not based on a percentage of capital contributions.
- Federal tax is separate from the limited liability provided to members under state law. Regardless of whether an LLC is taxed as a sole proprietorship, a partnership, or a corporation, the members are still protected from liability.
- An LLC can choose to be treated as a corporation in the eyes of the IRS by filing Form 8832, Entity Classification Election. Once it has elected to be taxed as a corporation, it can file a Form 2553, Election by a Small Business Corporation, to elect tax treatment as an S corporation.
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