As a small business owner, you probably want to protect your personal assets and reduce your federal tax rate, but navigating through the available legal options can be daunting. One choice is to have the Internal Revenue Service tax your business as an S corporation.
In order to be taxed as an S corporation, you need to notify the IRS that you are choosing, or "electing," this status. This process is known as an S corporation election.
"S corporation" stands for "Subchapter S corporation," a special tax status granted by the Internal Revenue Service. S corporations pass their corporate income, credits, and deductions through to their shareholders without having to pay federal corporate taxes.
S corporation is a tax designation, not a business entity type, which means you can't "incorporate" as an S corporation. To become one, you have to apply to the IRS.
The S corp election is a request filed with the IRS to change a business's tax status. When you elect S corporation status with the IRS, you are declaring your business as a separate and distinct entity from your personal finances.
After the IRS has approved the election, your business operates under the S corp status as long as it continues to meet the necessary requirements. Under this status, your business's earnings and losses pass down to all owners or investors, who then report the income on their individual income tax returns. Companies that file as an S corporation do not pay corporate income taxes.
To be approved for S corporation status, your business must meet the following conditions:
Filing for S corp status must be done no later than two months and 15 days after the first day of the taxable year. However, this depends on whether the business is new or has filed in previous years as a corporation.
Wondering what that means? Here are two possible scenarios to help you clarify this timeframe:
For example, say you've already filed your 2022 taxes, but you want to file as an S corporation in 2023. Your window to file for the S corp election began on January 1, 2023, and runs until March 15, 2023.
If your business satisfies the above requirements, you're ready to file for S corp status.
If you file Form 2553 after the due date, the IRS requires you to show reasonable cause for the late election. The form has six possibilities that the IRS accepts as reasonable causes. You may also attach a separate statement for a longer explanation for the filing delay.
Instructions for Form 2553 can be found on the IRS website.
Once the IRS grants your business the S corp status, IRS Form 1120S is used to report your company's income, deductions, profits, and tax credits for the year.
If your business currently operates as an limited liability company (LLC), you can still apply for the S corp election. Having both structures in place actually provides several benefits for your business:
There are several benefits to filing your taxes as an S corporation. Here are a few.
Avoiding double taxation is probably the most appealing benefit of choosing to file as an S corp.
Under normal circumstances, corporations are taxed at both the corporate and individual levels. When you file as an S corporation, though, your business is able to avoid this "double taxation." By filing as an S corporation, you gain all of the advantages of filing as a corporation but pay taxes as a pass-through entity similar to an LLC or sole proprietorship.
S corporations don't pay federal income tax and instead only pay employment tax (Social Security and Medicare) on employee wages. All other income goes to shareholders in the form of "distributions" that are not subject to self-employment tax.
Be careful, though: when you are an S corporation shareholder, you are considered an employee of the company and you must pay yourself a "reasonable salary" before paying yourself a tax-free distribution.
Owners of S corporations without inventory can use the cash method of accounting, which is less complicated than the accrual method. Income is taxable when received, and paid expenses are deductible. Additionally, there are no complicated accounting rules to follow when shareholders sell or transfer their ownership interest.
Learn more: Cash Basis Accounting vs. Accrual Accounting
In the event that you or any of your partners leave the business or sell shares, the business will continue to run under the S corp structure without interruption or interventions. The sold shares are transferred to the remaining owners.
S corporation status also makes selling the business easier, as any outstanding shares are simply transferred over to the new owners upon the business's sale.
While operating under the S corp tax structure has many advantages, it may not always be the best fit for your small business.
First, make sure that your business is generating enough income to satisfy the reasonable salary requirement. But how do you determine the dollar amount of a "reasonable salary?"
The IRS offers a list of possible factors considered by the courts to help you determine this amount. When settling on a salary, you should consider training and experience, job responsibilities, time and effort devoted to the business, and how much comparable businesses pay for similar services.
It may be tempting to pay yourself a lower salary to maximize your tax-free distribution, but in the case of an audit, you'll need to be able to justify your salary to the IRS.
For example, if you are the only owner and your business is clearing $50K in revenue, you could pay yourself a $40K yearly salary and still have $10K remaining for a dividend payment. The tax savings you'd realize on the dividend could cover your payroll expenses.
However, if you have additional owners to pay in the corporation, your yearly profit will have to be considerably higher to accommodate their salaries.
You should also keep in mind that the state where you operate your small business may not recognize the S corp status for state taxes. The state may also have additional franchise or excise taxes applied to S corps, and some states treat S corps like C corps for state tax purposes, meaning you'll only reap the benefits at a federal level.
It's a good idea to verify your state's requirements before moving forward with your application.
S corporation status isn't static. If something changes and your company can no longer meet any of the IRS requirements for S corporation status, the IRS can revoke S corporation status immediately and tax your business as a C corporation instead. This can create huge problems around tax time.
If you expect your company might violate one of the IRS's requirements—for example, if your fast-growing company plans to expand its shareholder base beyond the 100 allowed shareholders in the near future—S corporation status might not be for you.
How Accracy can help
Navigating tax requirements and designations can be confusing, especially when you're not a financial expert. When you change business structures, it means all new filing requirements for the IRS, which means changing up how you do your bookkeeping.
With Accracy, your expert bookkeeping team makes sure you never miss a step. We'll walk you through what a change in structure means for your business to keep your books up to IRS standards. Add in our tax filing solution, and you'll gain year-round tax advisory support in addition to an all-star team to prep and file your tax return. Learn more.
S corporation status can substantially reduce your taxes and make it much easier to sell your company, but it's not right for every business. Before starting the application process, you should carefully consider if your anticipated profits and number of prospective shareholders make this a feasible choice for your small business. As always, we'd advise speaking with a tax professional to help you navigate the process of the S corporation election.
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