You may have heard the term S Corporation (or S Corp for short) floating around. And even though it could be beneficial for your business, you still have no idea how it works or if it’s right for your business. Don’t worry – we’ll explain what an S Corp is, the tax benefits, how it works with an LLC, and step-by-step instructions for forming one.
Definition of an S Corporation
An S Corp is short for S Corporation and is sometimes referred to as a small business corporation). An S Corp is a tax classification that can be elected by businesses as its tax structure. Unlike an LLC or corporation, which are a type of business structure, an S Corp is solely a tax designation.
With an S Corp, profits and losses pass directly to shareholders (aka business owners) and aren’t subject to corporate income tax rates, avoiding double taxation. This setup could result in significant tax benefits for eligible businesses. The tax advantages of electing S Corporation status, like potentially reducing tax liability, incentivize small business owners to consider this option.
S Corp requirements
To qualify for the S Corporation tax status, businesses must meet certain IRS (Internal Revenue Service) criteria. One critical requirement is the limit on the number of shareholders, which cannot exceed 100 individuals.
Also, allowable shareholders must be U.S. residents or permanent residents. Non-resident aliens cannot be an S Corporation shareholder. All shareholders must be individuals or certain qualifying trusts or estates—business entities may not hold shares in an S Corp. Finally, an S Corporation can only have one class of stock, but it may have differences in voting rights.
How S Corp taxes work
When an S Corp is taxed, the business income, losses, credits, and deductions flow through to the shareholders’ personal income tax returns. Owners are taxed at their personal income tax rates.
S Corp owners pay federal taxes, as well as state taxes, on their S Corp business income at the personal shareholder level. This is known as “pass-through” taxation, which may also referred to as a “pass through entity.”
S Corp reasonable compensation
If shareholders also work for the S Corporation, they must receive reasonable compensation for their services. This compensation is subject to FICA taxes (often referred to as payroll taxes), which include Social Security and Medicare taxes. After payroll taxes are accounted for, any additional profits can be distributed to shareholders as distributions.
The reasonable compensation requirement is to prevent shareholders who work for the company from avoiding payroll taxes by taking all their income as distributions. Instead, a portion of their income is allocated as salary (subject to payroll taxes) and the remainder as distributions.
The salary portion must reflect fair market compensation for the work performed, mimicking what the salary would be for similar services in the market.
S Corp distributions
S Corporation distributions are the profit that’s left after the owners’ pay their salary and account for business expenses. Distributions are paid out on a schedule of the owners’ choosing and are only subject to regular income tax, paid through your income tax return. Unlike corporate dividends, distributions aren’t subject to capital gains tax and are treated as regular income for federal tax purposes. Both S Corp reasonable salary and distributions are reported on the owners’ personal tax returns as taxable income.
S Corp tax benefits
The tax benefit of an S Corporation status stems from the pass-through mechanism—an S Corp’s income is only taxed at the shareholder level, not at the corporate level. Profits distributed to shareholders as distributions aren’t subject to Social Security and Medicare taxes, making this an attractive benefit.
LLC taxed as S Corp
An LLC (Limited Liability Company) is a type of legal entity. The benefit of an LLC is that LLC owners are legally separated from their business’s liabilities and are not personally responsible in the event of a business lawsuit. With S Corporation tax status, LLC owners benefit from this liability protection but also receive the potential tax benefits of an S Corporation.
LLCs are commonly taxed as pass-through entities, similar to S Corporations, where profits and losses are reported on the owners’ personal tax returns. By default, LLCs are taxed like sole proprietorships, where all business income is subject to Social Security and Medicare taxes, paid through self-employment tax.
When an LLC elects S Corp status, it can split income into salary and distributions. This allows a portion of the earnings, the distributions, to avoid self-employment tax, potentially decreasing taxes owed compared to the default LLC tax treatment.
It’s crucial to understand that an S Corporation is not a business entity. An S Corporation is a tax election for a business entity and doesn’t change the company’s legal standing. An LLC can elect to be taxed as an S Corporation and, with this tax treatment, will remain an LLC in terms of its business structure.
Benefits of S Corp vs LLC
Consider, for example, Jane, a freelance graphic designer who makes $160,000 a year from her services. If Jane operates as an LLC, most of her business profits are subject to Social Security and Medicare taxes, which are 15.3% and paid via self-employment tax.
But, if Jane’s business elects S Corp status and she pays herself a salary of $60,000, she only pays Social Security and Medicare taxes only on her salary. The remaining $100,000 business profit is only subject to income tax.
So S Corp vs LLC offers Jane the opportunity to lower her tax bill by eliminating Social Security and Medicare taxes on the income she categorizes as distributions—the $100,000. This income would only be taxed at her personal income tax rate. For self-employed individuals and small business owners like Jane, the S Corp election can lead to considerable savings.
S Corp Formation
The first step to electing for S Corporation status is to establish a business structure, such as an LLC or corporation. To do this, first, you must select an appropriate state for formation and file the necessary formation documents with the state’s Secretary of State office. Once approved, be sure to comply with all state requirements, such as naming rules and associated fees.
Next, you’ll acquire an Employer Identification Number (EIN) by applying online at the Internal Revenue Service (IRS) website or by mailing in Form SS-4.
Once you have your EIN, you can complete and submit Form 2553 to the IRS, ensuring that it’s filed within two months and fifteen days (or 75 days) from the start of the tax year in which your election is to take effect. Make sure that all shareholders sign the form, as this is a requirement of the IRS.
Next is an oft-overlooked aspect: registering as an employer and setting payroll tools. You must register your business with your state’s workforce agency, which typically involves obtaining a state employer ID number and setting up an unemployment insurance tax account.
After registration, select a payroll processing system that will handle salary payments, withhold the appropriate taxes, and manage all necessary payroll tax filings. Remember, an organized approach to payroll management is imperative for meeting federal and state tax obligations and avoiding penalties associated with payroll tax compliance.
How to Convert LLC to S Corp
If you already have an existing business entity, like an LLC, you don’t need to form a new business entity. Instead, you’ll file Form IRS 2553 to have your existing LLC taxed as an S Corporation.
You can elect to have your LLC taxed as an S Corporation at any point in the year. However, according to Internal Revenue code, you have two months and 15 days (or 75 days) to make the election for the beginning of the year.
If you make the election after 75 days, then your business will be taxed like a sole proprietorship and may need to pay taxes on all of your pass-through profits and be subject to self employment tax liability.
Advantages and Disadvantages of S Corp
Now let’s take a look at the specific advantages and disadvantages.
Pros:
- Potential for significant tax savings due to shareholders’ ability to receive a portion of income as distributions, which are not subject to self-employment taxes.
- Avoid double taxation, which generally occurs with C Corporations who pay corporate taxes, as S Corps are pass-through entities.
- Maintenance of limited liability protection that shield’s a business owner’s personal assets from claims against the business.
Cons:
- Increased tax filing responsibilities, as S Corps must file specific forms and their own business tax return.
- Added levels of financial complexity due to the need to separate salary and distribution amounts for tax purposes.
- Ownership limitations, since S Corps can have only a specific number of shareholders, which may hinder investment opportunities and company growth.
Is an S Corp right for me?
While S Corp status is not ideally suited for every business, if you fulfill a specific set of conditions, it might be an advantageous election for tax purposes. Here’s what an ideal profile looks like:
- An established business that is financially stable with consistent profits, ideally generating at least $60,000 annually in self-employed income.
- A business owner who is a U.S. citizen or permanent resident ensures eligibility for S Corp status since non-resident aliens cannot be shareholders.
- The business should not be seeking foreign investors, as all shareholders must be domestic entities or individuals.
- Entrepreneurs who are seeking to eliminate self-employment taxes while maintaining limited liability protection.
Let’s Recap!
S Corps offers several tax advantages for those who fit the requirements, but the decision to shift your business should be made with careful planning and professional advice. If you fit the ideal S Corporation profile and are aiming to make the most of your tax situation, Collective can offer expertise on optimizing your tax structure.
Best part? Members who utilize Collective for their S Corporations save on average $10,000* per year in taxes. See how much you could save with our free tax savings estimator.*Based on the average 2022 tax savings of active Collective users with an S Corp tax election for the 2022 tax year
Garima Khatri is a freelance writer and content strategist for tech and fintech brands. Outside of work, you can find her exploring quaint coffee shops and binging on sci-fi series.