S Corporations (S Corps) are a common entity choice for closely held businesses. Whether you’ve been operating a while or you’re just getting started, it’s good to brush up on some basics.
S Corporations are taxed by the IRS as pass-through entities, unlike C Corporations that have to pay income tax at the corporate level. Because of pass-through taxation, the S Corporation itself typically doesn’t pay federal income tax on its business income, the way a C Corporation does.
Instead, business income, deductions, losses, etc. essentially flow-through (or pass through) to business owners. The S Corporation files a tax return with the IRS stating each owner’s share. Business owners must pay tax on their share of the S corporation’s income, even if the money stays in the business instead of being distributed.
For the closely held business, operating as an S Corporation avoids the “double-taxation” you would otherwise have to pay on C Corp dividends. The reason for this “double-taxation” is: C Corporations pay their own tax on income, and, C Corp shareholders generally pay tax on dividends. In this sense, C Corporation dividend income is taxable twice: once to the C Corp and a second time to the shareholder.
CT Tip: The idea behind S Corporation tax status was to help smaller corporations with only handful of owners, who otherwise would be under the same income tax rules as the mega-corporations.
Other aspects of S Corporations include:
- S Corporation dividends escape self-employment tax (unlike LLCs). Wages paid by an S Corporation to owner-employees are subject to FICA’s Social Security and Medicare tax, but S Corporation dividends are not subject to self-employment taxes. Be aware that the IRS closely watches this opportunity for splitting compensation and dividends. It may challenge salaries that aren’t “reasonable” in its view and try to recharacterize dividends as salary.
- Compared to LLCs, S Corporations can more easily convert to C Corporations. An S Corporation could be very beneficial if current or potential investors prefer a corporation.
S Corporation tax status is not “automatic” under IRS default rules, the way an LLC’s pass-through tax status is. To get S Corporation tax treatment, you have to qualify and properly make an IRS election.
CT Tip: State department of revenue tax rules may differ from the IRS rules. Although many states recognize federal S tax status, some don’t, and many have their own election rules. Keep this in mind when talking with your advisor about your business taxes.
“S Corporation” is special IRS tax treatment
An “S Corporation” is essentially an IRS-label for special IRS tax treatment.
Typically, a business owner forms a corporation by filing with a state. If the owner does nothing further, the corporation will be taxed as a C Corporation. For information on forming your corporation, see our discussion on C Corporations.
Or, if it qualifies, the corporation could file with the IRS to be taxed as an S Corporation instead.
CT Tip: The “S” designation relates to Subchapter S of the Internal Revenue Code, which applies to S Corporation small business corporations.
Getting S Corporation tax status from the IRS basically requires 1) meeting all IRS requirements, 2) properly making an S Corporation election, and 3) continuing to meet all IRS requirements for as long as you’d like S Corporation tax status.
The strict IRS requirements for S Corporation tax status include:
- Shareholders have to be individuals, certain types of trusts, estates, or certain types of tax-exempt organizations. For example, a partnership can’t be an S shareholder.
- The business must be a U.S. corporation with no more than 100 shareholders (related parties may count as a single shareholder)
- The business can have only class of stock (but, differences in voting rights among shares of common stock are permissible) and it can’t have a nonresident alien shareholder
Also, some types of businesses (e.g. financial institutions, insurance companies) aren’t eligible for S Corporation tax status even if they otherwise meet the IRS requirements.
With an S Corp, earnings are distributed proportionately to capital contributions. In this area, S Corporations offer more structure. On the other hand, LLCs offer more flexibility.
If you believe your business qualifies and you want to file for S Corporation tax status, talk to your accountant or advisor about ensuring your day-to-day operations don’t inadvertently terminate your S status and help preserve it over time.
Remember, an S Corporation is a corporation, even though it is taxed differently than regular corporations. It follows corporate formalities and has shareholders, directors and officers.
There’s no wait-and-see: S elections are due as your tax year begins
For a qualifying business to obtain S tax treatment, an S Corp election has to be properly made using the correct forms and within a certain period of time. If the election isn’t made by the deadline for the current tax year, the S Corp election will take effect for the corporation’s next year.
Elections for a tax year are due in the early part of that tax year, within a certain window. It has to be made during the corporation’s tax year and on or before the 15th day of the third month of its tax year.
CT Tip: If you find out that you missed an election deadline then IRS late election relief might be available, if you qualify.
For new corporations, the tax year almost never begins on Jan. 1. Getting the election filed in plenty of time avoids ensnarement in IRS rules on months, days, and computing time to see whether you made it in under the deadline for your first tax year.
CT Tip: A proper S Corp election is effective for all succeeding years until it’s terminated (either by you voluntarily, or by the IRS for violating S Corp rules). You don’t have to keep electing every year.
Also, all shareholders need to consent to the election. Without this unanimous consent, the election won’t be valid.
If S Corporation benefits appeal to you, talk to your advisor. Despite the many S Corporation rules, many closely held businesses still elect to be taxed as S Corporations.
An S Corporation “passes through” its income, expenses and losses to the shareholders in proportion to their ownership interest in the S Corp. And, an S Corporation can pay both salary and dividends. The way S Corporation dividends are taxed could save on the owner’s self-employment tax.
Under the IRS “check-the-box” regulations, it’s possible for an LLC to elect to be taxed as an S Corporation, provided it meets all requirements. Talk to your advisor if you’d like to do this.