As an owner of a traditional corporation or a limited liability company (LLC), you might want to reduce your company's tax burden. Perhaps you're thinking of electing S Corporation tax treatment. But because the Internal Revenue Services (IRS) has a number of restrictions and requirements for S Corps, that business structure is not an option for every business. You can elect S corporation status at any time after you form the business, so you can revisit the issue as your company grows and changes.
An S Corporation is not a particular business entity, but a tax status that certain types of companies can choose. When you form a corporation, it is automatically a C Corporation in the eyes of the IRS and your state's tax agency. To form an S Corp, after creating the corporation you can file additional paperwork with the IRS and state tax agencies, as discussed below.
LLC owners can also file paperwork to elect S Corporation tax status. An LLC is not "taxed as an LLC." Instead, the IRS and state tax agencies tax an LLC as a sole proprietorship (for single-owner and husband-wife owned companies) or as a partnership (for multi-owner companies). (Taxing the LLC through its owners is known as "pass-through taxation.") But like a corporation, owners of an LLC can file paperwork to elect S Corp status.
A C Corporation is not a pass-through entity. This means that the business must pay corporate taxes on its earnings. When the corporation pays dividends, the shareholders pay tax on the same income a second time, on their personal tax returns. Subjecting the corporation's earnings to two taxations—one upon earning the income, the other when shareholders receive dividends as income—doesn't sound very attractive. But entrepreneurs form C corporations nevertheless because a C Corporation can become a publicly-traded company with an unlimited number of investors.
By contrast, an S Corp does not pay corporate tax. The income passes through the entity to the owners (shareholders), and the shareholders pay tax for the first time on their personal tax returns. In addition, if you sell an S Corp, the taxable gain might be less than you would pay for the sale of a C Corp. That's why an S Corp is the preferred tax status for many corporations, particularly for smaller companies with a limited number of owners and investors.
An LLC that pays taxes as a sole proprietorship or a partnership already avoids the double-taxation problem and enjoys pass-through taxation. So what is there to be gained by electing a corporate status that primarily allows for that already-obtained pass-through tax treatment? The answer lies in realizing that you can gain another tax advantage: electing S Corp status offers LLC owners the benefit of avoiding self-employment tax (self-employment taxes include Social Security and Medicare taxes). Owners of LLCs that do not elect S Corp taxation must pay these self-employment taxes on all income they receive from the company. In contrast, an S Corp can allocate a portion of the company's earnings to the shareholders as distributions. Shareholders report these distributions as dividends, not as wages, which are not subject to self-employment tax.
At first blush, it might seem like forming an S Corp is a sure-fire method to avoid self-employment tax. All you need to do when moving money from the company to the owner is to distribute it as a distribution! But this dodge won't entirely succeed if you are involved in running the business. If the owners are employees of the company (and not passive investors), the IRS requires S Corps to pay the owners a reasonable salary before making any S Corp distributions. For example, if your LLC brought in $100,000, and an employee in your position might make $60,000, you can report only $40,000 as S Corp distributions. In this case, you must report $60,000 as income, which is subject to self-employment tax.
While an S Corp can reduce your tax burden, it is not an option for every business. Tax regulations include a number of requirements for S Corps, and the IRS highly scrutinizes S Corps to ensure compliance. If you do not meet all of the following, you cannot elect S Corp status. Your company must:
Forming a business with S Corp status begins with creating either a corporation or an LLC. When completing the formation paperwork and drafting internal documents like your operating agreement, keep in mind the S Corp requirements. For instance, you might limit the number of owners and shareholders, and allocate profits and losses in proportion to each owner's interests.
After you form the entity, you must file Form 2553 with the IRS within two months and 15 days of the date of formation to enjoy S Corp status your first tax year. For instance, if you formed the company on May 1, 2020, you have until July 15, 2020 to file. If you do not file the paperwork in time, this does not preclude you from applying for S Corp status, but it would not begin until the following tax year.
In many states, once the IRS approves your S Corp paperwork, your state tax agency will automatically recognize your business as an S Corp. In other states, you must file additional paperwork with the state tax agency to elect S Corp status at the state level.