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Tax Implications of S Corp Election: The Small Business Guide

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    Key Takeaways:

    • An S corporation is a type of tax status that allows pass-through taxation, which avoids the double taxation other corporations experience
    • Many businesses pursue S corp election to take advantage of additional tax benefits, like lower payroll tax costs
    • Requirements for S corp election:
      • No more than 100 shareholders
      • Only allowable shareholders
      • Only domestic corporations
      • Only one class of stock
      • No ineligible corporations
      • File within 2 months and 15 days of the taxable year
    • Six steps to elect S corporation status:
    1. Talk to a tax expert about options
    2. Choose a business name
    3. Assemble a board of directors
    4. Create and file bylaws
    5. File Form 2553
    6. Provide reasonable cause if filing late
    • Benefits of S corp election for small businesses:
      • No double taxation
      • More distribution flexibility
      • Payroll tax savings
      • More legal protection
      • Negotiation leverage
      • Retain earnings
      • More appealing to investors
      • Succession planning

    Business owners have a lot on their plate, including hiring and managing staff, completing all reporting requirements, paying taxes, getting new customers, monitoring finances, and many other moving parts. One of a small business owner’s biggest considerations is what kind of business structure to use. Each comes with different responsibilities and requirements, and they’re taxed differently. 

    An S corporation is a type of tax status that offers certain tax advantages to businesses, from limited liability companies (LLCs) to partnerships to corporations. Unlike traditional corporations, which are subject to double taxation, S corporations enjoy pass-through taxation, so income is taxed at the shareholder level. This can potentially reduce the business’s overall tax burden.

    Being taxed as an S corporation has a lot of advantages, but it doesn’t happen automatically. Small businesses have to elect to be taxed this way. This guide covers everything you need to know about S corp election and tax implications for small businesses.  

    What Is S Corp Election?

    S corporation election can have a big impact on your small business. This is a tax status the IRS grants, and it provides certain tax advantages, including the ability to distribute profits in a more flexible manner. S corporation election does, however, come with certain obligations and restrictions that all business owners should be aware of before making the election.

    S corp election must be made at the federal level through the IRS, as well as in any states where the business operates. It allows companies to pass through their corporate income, deductions, credits, and losses to the shareholders for tax purposes. “Pass through” means income from a corporation is taxed at a person’s ordinary income tax rate on their personal Form 1040 tax return—they are taxed according to their distributed profit or loss on their individual federal income tax returns, which can result in lower their overall taxes due. This means the company’s income is only taxed once, which is one benefit of making an S corporation election with the IRS.

    It’s also worth noting that S corp election provides flexibility when it comes to distributing profits among shareholders, giving business owners more control. This can result in significant savings when it comes time to pay payroll taxes, Social Security and Medicare contributions, and other self-employment taxes associated with wages or salary payments because profits are not considered wages. S corporation owners can also use the cash method of accounting instead of the more complicated accrual method.

    The downside is that there are certain restrictions when it comes to ownership structure and activities to account for. There are specific record-keeping requirements, distribution rules, annual meeting requirements for shareholders, and limits on how many shareholders a company can have at any given time. An S corporation may potentially lose its special taxation treatment if it fails to comply with certain regulations from the IRS, resulting in even higher owed taxes by both the company and its shareholders.

    Whether or not making an S corporation election would ultimately be beneficial depends on a variety of factors like state laws, business type, and financial goals. Understanding the potential implications is essential before committing to it long term.

    Who Should Pursue S Corporation Election?

    S corporation election isn’t the best option for all businesses. For example, large businesses should not pursue this path since there are shareholder limits. Here are the full requirements to see if your business can qualify to make this election:

    • Shareholder types: S corporations can only have “allowable” shareholders, which are individuals, certain kinds of trusts, and estates. “Non-allowable” shareholders are partnerships, corporations, and non-resident aliens. 
    • Number of shareholders: S corporation status can’t be given to companies with more than 100 shareholders. Bigger businesses with more shareholders than that don’t qualify, for example.
    • Domestic corporations: Businesses must be domestic corporations, meaning they were formed and operate in the United States, to meet this requirement. 
    • Stock classes: Businesses can have only one class of stock to be taxed as an S corporation.
    • Ineligible corporations: The IRS defines ineligible corporations as some financial institutions, insurance providers, and sales corporations. These would not qualify for S corp tax status.
    • Filing timing: You don’t have forever to file for this status. You must do it within 2 months and 15 days following the first day of the taxable year.

    Deciding to elect S corporation status can mean tax savings and other benefits for your small business. Make sure you meet all requirements and have considered the move from all sides before taking action. Talking to a tax expert can help you make the best decision for your business goals.

    The Difference Between an LLC and an S Corporation

    LLCs often elect to be taxed as S corporations. You may be running an LLC already, so it’s important to understand how they differ from S corporations. An LLC is a type of business structure, while an S corporation is not. It is just a tax status. Legally, your LLC will still be an LLC.

    An LLC can be taxed as a sole proprietorship, partnership, C corporation, or S corporation. A one-member LLC will be taxed as a sole proprietorship, and an LLC with more than one member will be taxed as a partnership, by default. These two tax statuses mean the LLC will benefit from pass-through taxation, avoiding the double taxation of a C corporation. S corporations also do not have to pay self-employment taxes, which can be a huge advantage of S corps over LLCs.

    An LLC taxed as an S corp means you will still have that pass-through taxation but also more relaxed administrative responsibilities, since you’re considered an LLC from a legal standpoint. You may see other tax advantages, like lowering your payroll tax responsibility. These are the primary reasons an LLC would file for S corporation election.

    A C corporation can also elect to be taxed as an S corporation in some situations. Note that larger businesses that don’t meet the requirements for S corp election discussed above will not qualify for this status. The main benefit of S corp status, however, is to take advantage of pass-through taxation and avoid the double taxation that corporations experience. Double taxation happens when business income is taxed on the corporate level as well as at the shareholder level.

    Six Steps to Elect S Corporation Status

    S corporation status provides some clear tax benefits to certain businesses. It is pretty simple, fortunately, for the average business to elect S corp status. Here are the six key steps to follow when you’ve decided this is the right route for your company:

    1. Talk to a Tax Expert About Options

    The first step is to make sure you talk through your business structure and taxation options with a trusted tax professional. How your business is taxed will have big implications for your goals and your bottom line. Never make this decision lightly. 

    2. Choose a Business Name

    You’ll need a business name if you don’t have one already. It’s ideal to choose a name that isn’t already being used by another corporation. Spend some time researching the right name for your situation.

    3. Assemble a Board of Directors

    Your S corporation will need a board of directors to represent shareholders. Take the time you need and get insight from experts and other resources to make these decisions.

    4. Create and File Bylaws With Your Local Office

    You will need to write corporate bylaws for your business, including details such as when meetings will be held, how stocks will be sold, voting rights of shareholders, and more. These should be filed with your secretary of state.

    5. Send Form 2553

    Complete IRS Form 2553, Election by a Small Business Corporation, and file it with the IRS. You will need the personal information of all shareholders, their percentage of ownership, and their signatures, among other details.

    6. Provide Reasonable Cause if Filing Late

    Filing after the deadline for the year means you have to provide reasonable cause to the IRS for why you’re submitting it late. You will write down your reasoning on Section I of Form 2553.

    There are many reasons small businesses decide to be taxed as S corporations. The tax implications could mean significant savings, and LLCs can continue their current administrative responsibilities while enjoying those benefits. A tax professional can help you understand all implications for your specific situation. 

    Benefits of S Corp Election for Small Businesses

    S corporation status isn’t right for all large businesses, since there are requirements that need to be followed and limits on shareholder numbers. Small businesses, however, can decide to make this election to get the tax benefits. Here are the benefits of electing S corporation status as a small business:

    • No double taxation: The company’s income is only subject to one level of taxation, so taxes paid will be lower.
    • More distribution flexibility: S corporations have more flexibility when it comes to distributing profits among shareholders.
    • Payroll tax savings: The payroll taxes or Social Security and Medicare contributions that are typically assessed on wages or salary payments are saved, since profits are not considered wages and do not require such contributions.
    • More legal protection: Small businesses can take advantage of certain legal protections that are not available under other types of business structures, like sole proprietorships.
    • Negotiation leverage: Having S corporation status helps businesses when negotiating contracts, finance opportunities, and purchases with suppliers.
    • Retain earnings: Small businesses will also have the opportunity to retain earnings within the company rather than pass them through as distributions, which can make them vulnerable to creditors and personal judgments against individual shareholders. S corporations can allocate to shareholders, retain the earnings, or do both.
    • More appealing to investors: S corporations can attract investors by allowing them a partial ownership stake in the company with more favorable tax treatment compared to partnerships or LLCs.
    • Succession planning: Ownership can be transferred more easily from one shareholder to another without triggering corporate restructuring requirements, so succession planning is easier.

    S corporation status can help a range of small business structure types, including sole proprietorships and LLCs. Businesses may want some additional protection and credibility while taking advantage of the tax benefits of pass-through taxation.

    Contact Silver Tax Group With S Corporation Questions

    Tax planning should be a top priority for your small business. You need to be aware of S corp election tax implications, as they can have a big impact on reporting requirements and taxes each year. Understanding the advantages and disadvantages associated with S corporation status, and weighing them against your circumstances and goals, is essential to making the right decision to move forward. 

    It isn’t easy to figure out which business structure or taxation status is right for your business. Consulting with a qualified tax advisor can help you ensure all requirements are met before electing to become an S Corporation. 

    The team at Silver Tax Group is ready to help you and your small business. We understand the applicable tax laws, including those in your area, and can guide you through the process. We can also help with general tax consulting, debt resolution, audits, tax defense, accounting, and much more.

    Reach out to Silver Tax Group to speak to a tax expert about S corporation election and its tax implications.

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