Is an S Corporation Right For You
Many people don't realize that an S Corporation isn't a business entity type in itself but rather a tax election that eligible limited liability companies (LLCs) and C Corporations may choose.
“S Corporation” (or “S Corp”) is formally known as “Subchapter S Corporation,” named after the section in which it appears within the Federal Internal Revenue Code.
Choosing the S Corporation election may provide significant tax advantages for some businesses. However, it’s not ideal for every business. Therefore, entrepreneurs should get expert tax and legal guidance when considering if it will be right for them.
Let’s take a moment to look more closely at the S Corp—specifically…
- What constitutes an “eligible” LLC or C Corp?
- Why might a company opt to be treated as an S Corporation?
- Are there any potential drawbacks to S Corporation status?
- What’s involved in becoming an S Corp?
S Corporation Eligibility Requirements
The IRS website shares the criteria for qualifying for S Corporation status. The requirements include:
- Be a domestic corporation (in the case of an LLC, it must first file to be treated as a corporation for tax purposes before filing for S Corp status).
- Have only allowable shareholders (may be individuals, certain trusts, and estates; may not be partnerships, corporations, or non-resident alien shareholders).
- Have no more than 100 shareholders.
- Have only one class of stock.
- Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).
Pros and Cons
Potential Advantages of S Corporation Election
Below are some of the ways tax treatment as an S Corp might benefit a business.
- May help reduce LLC members' Social Security and Medicare tax burden – Normally, an LLC is considered a “disregarded” pass-through tax entity. An LLC’s profits pass through to its owners’ personal tax returns. LLC members pay income tax and self-employment taxes (Social Security and Medicare) on all of the business’s profits. As an S Corporation, however, only wages and salaries paid to LLC members through payroll are subject to Social Security and Medicare taxes. Remaining profits paid as distributions to members don’t get hit with those taxes.
- Allows LLCs to retain their administrative simplicity – Generally, an LLC's business compliance obligations remain the same after electing S Corp status. There may be additional tax reporting requirements, but usually, the formalities to maintain the entity remain the same.
- Helps C Corporations and their shareholders avoid double taxation – A C Corporation pays income tax on its profits at the corporate tax rate. Then, profits that the company pays as dividends (which are not tax-deductible for the C Corp) get taxed again on the shareholders' personal income tax returns. However, with S Corporation tax treatment, the corporation's profits and losses flow through to its shareholders' individual tax returns immediately without getting taxed at the corporate rate. Shareholders employed by the corporation pay Social Security and Medicare taxes only on the wages or salaries they receive from the business. They do not pay Social Security and Medicare taxes on income paid to them as dividends.
- May increase a company’s credibility – A business might find that potential customers, vendors, and partners will perceive it as more credible and trustworthy if it operates as an S Corporation rather than a sole proprietorship, partnership, or LLC.
Potential Disadvantages of S Corporation Election
The choice to be taxed as an S Corp isn't the right decision for every business. Below are some of the potential downsides.
- Stringent ownership requirements – LLCs and C Corporations have fewer restrictions on who may own them. However, only eligible domestic corporations and LLCs qualify for S Corp status. Also, there are restrictions on who may be shareholders of a corporation that elects to be an S Corp, which prevent partnerships, corporations, and non-resident aliens from ownership.
- May limit growth –S Corporations may not have more than 100 shareholders. In contrast, LLCs can have unlimited members, and C Corporations can have an unlimited number of shareholders.
- Only one class of stock allowed – Unlike C Corporations, an S corporation may only have one class of stock. This restriction may make the company less appealing to investors.
- Lack of consistency in how states treat S Corporations – Some states honor federal S Corp status automatically for state income tax purposes, some states require additional filings to complete S Corp election at the state level, and then other states disregard S Corp election entirely.
- May be watched more closely by the IRS and other tax authorities – Businesses with S Corp status must be careful when setting up owners on payroll. Wages and salaries must be reasonable for the type of work the owner is doing and in line with industry standards. Suppose an S Corp pays its owners uncharacteristically low wages so that it can dole out the majority of the profits as distributions (to reduce self-employment taxes substantially). That may make the IRS suspicious. In response, the IRS may recharacterize the company’s wages and distributions—possibly affecting tax outcomes unfavorably.
- Higher shareholder tax burden under some circumstances – An S Corp’s pass-through taxation (business income taxed at the individual tax rates) may result in putting shareholders of a corporation in higher tax brackets. Ultimately, this could result in them paying more in taxes than if the business opted to be taxed as a C Corporation.
- Required to use a calendar tax year – Unless it has IRS approval for an alternate arrangement (IRS Form 8716 – Election to Have a Tax Year Other Than a Required Tax Year), an S Corporation must adopt a calendar year for its tax reporting.
How to Become an S Corporation
If a sole proprietor or partnership wants the advantages of being an S Corp, the business must first form an LLC or incorporate as a C Corporation—and meet the IRS’s other eligibility requirements.
LLCs must file IRS Form 8832 (Entity Classification Election) to identify they want to be classified as a corporation for federal tax purposes. Then they must file IRS Form 2553 (Election by a Small Business Corporation) to request Subchapter S Corporation tax treatment.
C Corporations must file IRS Form 2553 to request to be taxed as an S Corp.
For S Corporation tax treatment by the state (if available), businesses must complete any applicable state forms.
Business owners who are not familiar or confident with the process can request their accountant or attorney's help or enlist the services of a company that specializes in filing business forms with the IRS and state governments.
Where You Can Get More Information and Guidance
Because deciding on a business entity type and choosing the S Corporation election can impact your business legally and financially, it’s wise to talk with your attorney and accountant or tax advisor about how a change will affect you and your company. Many factors come into play, and your situation, even if similar to other businesses, is unique. Also, review information on the IRS website about an S Corp’s tax responsibilities.
Last, but most certainly not least, tap into the knowledge and experience of a SCORE mentor for guidance on ways to grow your business and ensure its success!