Of all the business entities someone could form, the S corporation is likely the most widely misunderstood. This is because the S corp is a tax designation rather than an actual business entity. Both limited liability companies (LLCs) and corporations can file to be taxed as an S corp. However, no state offers entrepreneurs the option to incorporate their business as an S corp; instead, those who want an S corp must file a form with the Internal Revenue Service (IRS).
The S corp's somewhat foggy formation process is not the only thing that creates confusion. It is a common misconception that S corps will automatically save owners 15% on their taxes. To dispel any myths and explain more about S corporations, below you'll find a complete breakdown of what the S corp actually is, how to form one, and what you should know before you do.
What is an S Corporation?
The S corporation is a tax designation that a corporation or LLC can elect by filing Form 553: Election by a Small Business Corporation with the IRS. It’s a popular tax election because it has tax-saving potential for both corporations and LLCs.
The S election gives a corporation the tax advantages of a pass-through entity. The S election can also give an LLC the tax advantage of corporate distributions, which aren’t subject to self-employment taxes. These tax benefits are explained in detail below.
Tax Benefits: S Corporation vs C Corporation
When someone forms a corporation, it is by default taxed as a C corporation. The money a C corp earns as net profit (the money left over after salaries and other expenses have been paid) will be taxed. Then, the net profit that is left over and not kept in the company will be distributed to the shareholders as dividends.
On these dividends, the shareholders will have to pay personal income tax. Essentially, the net profit of a C corp is taxed twice—once as a corporation tax, then again as personal income to the shareholders. This is known as double taxation.
The S corp tax designation allows corporations to avoid double taxation. S corps are pass-through tax entities. This means that the corporation itself is not taxed on its profits. The profits are passed onto the shareholders and are taxed as personal income, much the way an LLC is taxed.
Tax Benefits: S Corporation vs Default LLC
As explained above, the S election allows a corporation to avoid double taxation. LLCs, by default, are also taxed as pass-through entities, avoiding double taxation. Just like in an S corp, profits in an LLC pass directly to the members and are taxed as personal income.
In other words, LLCs don’t really gain any benefit from an S corp’s pass-through entity status. However, there is a different advantage an S election can give an LLC: self-employment tax savings.
For an LLC that keeps its default tax status, the IRS considers all the income passed through to members to be self-employment income. This means that the members of an LLC must pay self-employment taxes on their entire share of income—and these are hefty taxes. Self-employment taxes include social security (12.4%) and Medicare (2.9%), totaling 15.3%.
S corps, on the other hand, are allowed to pay out dividends to their shareholders. Dividends come from the net profits —what's left over after all expenses are paid. Shareholders are not required to pay self-employment taxes on these dividends, which is a savings of 15.3%.
However, there is a catch: The IRS requires that active owners of S corps (those who provide more than minimal services) pay themselves a wage, and the wage must be "reasonable compensation." That means you can't simply take all the S corp profit as a dividend —you must pay yourself a reasonable wage, which will be taxed as standard payroll wages.
S corp owners can only reap the 15.3% tax savings on dividends.
When to Choose the S Election
Because S corps owners are required to pay themselves a salary and receive the tax benefit only on dividends, many businesses choose to wait to elect S corporation status until the income the company generates makes the tax designation worthwhile. As a general benchmark, many entrepreneurs will wait until their company starts clearing $50,000 of annual profit. Because of the expenses incurred through payroll services and general W2 wages, $50,000 is where things start to make fiscal sense.
For example, if you took in $50,000 and paid yourself a $40,000 salary, you would have $10,000 left over as a dividend payment. At that point, the tax savings on the $10,000 dividend ($1,530) would likely cover payroll expenditures.
S Corporation Requirements
Although the S corp can present entrepreneurs with a wide range of advantages, it is not without its restrictions. Below are requirements for LLCs and corporations seeking S corporation tax status:
- LLCs and corporations that file to be taxed as an S corp must be domestic companies
- Shareholders or members of S corps must be individuals, estates, or certain types of trusts; S corp shareholders cannot be partnerships, other corporations, or non-U.S. residents
- S corps may only have one class of stock
- An S corp may have no more than 100 shareholders (or members if an LLC)
- Certain types of corporations do not qualify: some financial institutions, insurance companies and domestic international sales corporations
- All shareholders or members must pay themselves a reasonable salary
- Shareholders or members are directly responsible for the profits and losses according to their share of ownership
Filing Form 2553
As mentioned above, to apply for S corporation tax status, you’re required to fill out Form 2553 with the IRS. The form is fairly straightforward. However, there are a few key details about the form itself that you should know before you begin:
- You must file for the S corp tax designation no later than two months and 15 days after the first day of the taxable year
- On the form, you must include each shareholder or member’s name, address, social security number (or EIN if applicable), and tax year end date
- You must also list each shareholder or member’s number of shares or percentage of ownership, as well as the dates the shares or percentages were acquired
- All shareholders or members must consent to the S corp election by signing and dating Column K of the form
For thorough instructions on filing for the S election, see the Instructions for Form 2553.
Although the S election has developed a reputation as an optimal tax designation, it isn’t always the best choice for every business—particularly if your business isn’t making enough money to cover the mandatory salary requirement of “reasonable compensation.” Additionally, many businesses are not able to qualify for the S election at all due to the restrictions on stock classes, shareholders, domesticity, and areas of business. In fact, there are many misconceptions about S corporations to consider before electing with the IRS.
It’s also important to remember that the S election is a federal tax designation, affecting your federal taxes. State taxes may be very different, so it’s a good idea to research how your state treats S corporations.
Most states recognize the S election and will tax your business in much the same way as it is taxed on the federal level. However, some states don’t recognize the S election for state-level taxes and others have franchise or excise taxes that may apply to S corporations.
That said, the S election has greatly benefited some corporations and LLCs with considerable tax savings. Just remember that no single tax designation is inherently superior—it’s all about what’s best for your business
Copyright © 2023 SCORE Association, SCORE.org
Funded, in part, through a Cooperative Agreement with the U.S. Small Business Administration. All opinions, and/or recommendations expressed herein are those of the author(s) and do not necessarily reflect the views of the SBA.