Choosing the right entity requires well-detailed research on how the guidelines and restrictions will impact your business taxes, management structure, and ability to form subsidiaries and issue stock. While there are numerous options available, a good number of businesses are beginning to adopt the S Corp status.
However, note that an S corporation isn’t a business entity like an LLC; rather, it is an elected tax status. An S corporation, also known as an S Corp or S subchapter, is a tax election that allows the IRS to note that your business needs to be taxed as a partnership.
It also averts your business from acquiring corporate-level double taxation. Howbeit, to elect an S Corp, your business must first register as a C corporation or LLC. In an S Corp, the business owners are called shareholders. As an owner, you are noted as an employee for tax purposes and will have to pay yourself a reasonable salary.
Note that S Corp’s profits, losses, deductions, and credits are taxed at the shareholder level. While S Corps may make more sense financially, however, unless there is a specific reason to make the switch, it may not be the best move for a single-member LLC.
As the owner of a corporation with S Corp status, you are not considered a self-employed person. Owing to that, you are not expected to pay federal self-employment tax. However, since you are more or less considered an employee, you will have to take some or all of your company’s available profit as a salary. Also, note that you can take the remaining profit as a dividend to evade employment-related taxes and double taxation.
What are the Requirements for S Corp Status?
Have it in mind that not every corporation qualifies for S Corp taxation. In the United States, the IRS has established strict requirements for corporations who intend to elect S Corp status, and it’s most often limited to smaller, domestically owned companies. The requirements can be broken down into various segments, and they include;
Entity and Structural Requirements
In the United States, note that only domestic corporations are permitted to elect for S Corporation taxation status. This simply means that the business must have been formed or incorporated within the United States. Aside from that, the S Corporation must also not be ineligible.
The IRS notes ineligible corporations as “certain financial institutions, insurance companies, and domestic international sales corporations.” If you own or manage any of these types of businesses, it is recommended you speak with tax professionals before making the move.
Also note that your corporation will need to have one class of stock, neglecting differences in voting rights. Since corporations do not issue stock, you should reach out to a lawyer or accountant to find out how this requirement applies to your business.
Also note that your S Corporation will be expected to meet certain strict requirements for the shareholders (or members, in the case of an LLC) who own your business. You are not expected to have more than 100 shareholders to qualify as an S Corporation.
You will also be expected to have what the IRS notes as “eligible shareholders,” and this entails that shareholders will have to be individuals, certain trusts, or estates. Shareholders will also need to be U.S. citizens or legal residents. Partnerships and corporations are not allowed to be shareholders.
Although profits from corporations elected to be taxed as an S Corporation aren’t subject to federal corporate income tax, your state may have different rules. A good number of states in the United States fully recognize S Corps, while others treat them as C-corps or warrant additional eligibility or filing requirements. You may have to file a separate state tax return for your S Corporation.
Have it in mind that you can elect S Corp status by filing Form 2553 with the IRS coupled with filing any forms required by your state or jurisdiction.
Just as it was noted above, you are expected to have unanimous shareholder consent and meet the corporation and shareholder requirements outlined above to become an S Corporation. After you must have filed Form 2553, you will have to file an annual tax return that shows your business’s election as an S Corp.
Steps to File for S Corp Status
If you are looking to elect S Corp status for your corporation, here are steps to consider;
Form 2553 for Election to Be Taxed as an S Corp
To elect S corporation tax status, you will have to file IRS Form 2553, Election by a Small Business Corporation. Have it in mind that this form provides the IRS with comprehensive information about the corporation requesting S Corp status and about the corporation’s eligibility for electing this status. You will need the following information to file Form 2553:3
- The name and address of your corporation
- The employer ID (EIN) of the corporation
- The date and state of incorporation
- If the corporation has changed its name or address after applying for S corporation status
- The tax year for which the election is to be effective (You have several options for selecting a tax year.)
- If you have more than 100 shareholders but you are treating members of a family as one shareholder to keep the number under 100, there is a box to check.
- Name, address, and phone number of a corporate officer or legal representative who can be contacted for more information.
- If you are filing the election late, you have the opportunity to claim that you had “reasonable cause” for filing late.
- The final section asks you to list all the shareholders who must consent to the election, with the number or percent of shares owned, the date acquired, and the tax year of each shareholder. Each shareholder must also sign and date the form.
- Part II includes questions about the corporation’s tax year.
Part III: This part will have to do with Qualified S Trust Elections.
Part IV: This part relates to Late Corporate Classification Election Representations
Time Your Tax Election
Right before you choose to have your corporation elect S corporation status; you must verify that you are eligible to make this election. You will also be expected to make the election at a specific time, and this will have to do with the tax year it will become effective. You will also have to designate a tax year beginning with a specific month, day, and year. You are expected to complete and file this form:
- No more than two months and 15 days after the beginning of the tax year the election is to take effect, or
- At any time during the tax year before the tax year, it is to take effect.
For instance, if you designate January 1, 2022, as the beginning of your tax year, you must file the election in 2021, but no more than March 15, 2022.
A good number of entrepreneurs prefer to set up their new businesses as LLCs to guarantee some legal protection for their assets. However, as your business grows, it is recommended you reach out to a well-experienced and trusted CPA and look into filing as an S-corp.
Also make sure to take into consideration how many investors, stock classes, and foreign owners will be members of your LLC to ensure you comply with the requirements and guidelines under your state laws.