For many small business owners in the United States, choosing the right business structure is crucial for maximizing tax benefits and ensuring operational efficiency. Among the various options available, electing to become an S Corporation (S Corp) can offer several significant advantages.

This article explains what an S Corp is, how to elect S Corp status, and the benefits an S Corp election provides for a business entity, whether a Limited Liability Company (LLC) or a Corporation.

An S Corporation, or S Corp election, is a special type of tax treatment for LLCs or Corporations that meets specific Internal Revenue Code requirements. By electing S Corp status, an LLC or Corporation can pass corporate income, losses, deductions, and credits directly to shareholders, avoiding double taxation that typically affects C Corporations.

To become an S Corp, a business must:

1. Be a Domestic Corporation: The business must be incorporated in the United States.
2. Eligible Shareholders: Shareholders must be individuals, certain trusts, and estates. Partnerships, corporations, and non-resident aliens are not eligible.
3. Limit on Shareholders: There can be no more than 100 shareholders.
4. Single Class of Stock: The corporation can only have one class of stock, although voting rights can differ.

To elect S Corporation status, a qualifying Limited Liability Company (LLC) or Corporation must take specific steps to comply with IRS requirements. This involves completing and submitting Form 2553, titled Election by a Small Business Corporation, to the Internal Revenue Service (IRS). This form must be signed by all shareholders of the corporation or, in the case of an LLC, by all members consenting to the election. The form formally notifies the IRS of the entity’s decision to be taxed as an S Corporation, allowing the business to benefit from pass-through taxation while maintaining certain corporate advantages.

The form requires detailed information, including the business's name, address, Employer Identification Number (EIN), and tax year. Additionally, all shareholders or members must agree to the election and meet the IRS's eligibility criteria, such as being U.S. citizens or resident aliens, having fewer than 100 shareholders, and using only one class of stock.

To ensure the election applies to the current tax year, Form 2553 must generally be filed no later than 2 months and 15 days after the beginning of the tax year. If this deadline is missed, the election may still be made, but it would apply to the following tax year unless relief for late filing is granted by the IRS.

Failure to meet these filing requirements or include all necessary signatures and information can lead to delays or rejection of the S Corporation election. Once the election is approved, the business must adhere to ongoing compliance requirements to maintain its S Corporation status.

Similar to a Limited Liability Company, one of the most significant benefits of making an S Corp election  is pass-through taxation. Pass Through Taxation means that the corporation’s income, losses, deductions, and credits pass through to shareholders to be reported on their personal tax returns. This avoids the double taxation scenario of a C-Corporation where income is taxed at both the corporate level and again at the individual level when distributed as dividends.

S Corp shareholders who are also employees of the company can save on self-employment taxes. While self-employment income is subject to Social Security and Medicare taxes, S Corp income distributions are not. Shareholders only pay self-employment tax on their reasonable salaries, not on distributions, potentially resulting in significant tax savings.

S Corps can deduct various business expenses, reducing taxable income. These deductions can include salaries, bonuses, equipment purchases, and even health insurance premiums for employee-shareholders, providing further tax advantages.

While S Corp election offers many benefits, it is essential to be aware of the potential downsides:

• Strict Eligibility Requirements: Meeting and maintaining the eligibility requirements can be challenging.
• Reasonable Compensation: The IRS requires that employee-shareholders receive reasonable compensation, which can be subjective and may invite scrutiny.
• Administrative Complexity: S Corps have ongoing filing and administrative requirements that can be more complex than those for sole proprietorships or partnerships.

C Corps can have an unlimited number of shareholders, making them an ideal choice for businesses planning to grow significantly, seek angel or venture capital investments, or go public.

Unlike S Corps, C Corps can have shareholders who are non-resident aliens, other corporations, partnerships, and various types of trusts. This flexibility can be beneficial for businesses with diverse ownership structures or international investors.

C Corps can issue multiple classes of stock, allowing for greater flexibility in raising capital and structuring the company. This can include common stock with varying voting rights or preferred stock with different dividend rights.

C Corps can offer a wider range of tax-deductible benefits to employees, such as health insurance, retirement plans, and fringe benefits, which can be more extensive than those available to S Corps.

For businesses that reinvest profits rather than distributing them to shareholders, the corporate tax rate may be lower than individual tax rates. This can be advantageous for companies aiming to grow their retained earnings.

C Corps have more flexibility in how they handle net operating losses, including the ability to carry losses forward to offset future taxable income, which can be beneficial during periods of fluctuating profits.

• Double Taxation: C Corps are subject to double taxation, where the corporation pays taxes on its income, and shareholders also pay taxes on dividends received.
• Complexities and Cost: Forming and maintaining a C Corp can be more complex and costly than other business structures due to regulatory requirements and administrative tasks.

Choosing S Corp election can provide substantial tax advantages and operational benefits for many LLCs and Corporations. However, it’s essential to weigh these benefits against the potential drawbacks of making the S-Corp Election under the IRS Tax code. Consulting with a tax professional or financial advisor can help determine if S Corp status is the right choice for your business.*

*The information provided on this blog is for general informational purposes only and does not constitute legal or tax advice. You should consult with your legal and tax professionals who can provide invaluable guidance tailored to your specific needs and circumstances.

Della Torre Law PLLC