What is an S Corp Election? A Guide for Small Businesses

  • Accracy
  • 26th Nov, 2023

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.

What is an S Corp Election? A Guide for Small Businesses
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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.

What is an S corporation?

"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.

 

What is an S corporation election?

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.

Requirements for filing for S corp status

To be approved for S corporation status, your business must meet the following conditions:

  • Be a domestic corporation
  • Have only allowable shareholders
  • Allowable shareholders include individuals, certain trusts, and estates
  • Non-allowable shareholders include partnerships, corporations, or non-resident aliens
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation (according to the IRS, this means certain financial institutions, insurance companies, and domestic international sales corporations).

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:

  • If your business is brand-new and began its first tax year on January 7, your filing window ends March 21. You'd have to file for S corp status between January 7 and March 21.
  • If your business is currently operating as a C corporation, you may file for the election at any time during the preceding tax year. You have up until two months and 15 days after the start of the year you plan to file as an S corp.

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.

How to elect S corp status

If your business satisfies the above requirements, you're ready to file for S corp status.

  • If you do not already have one, choose a name for your S corp. You can check with local and state offices for a list of existing corporations to ensure the name you selected hasn't been used.
  • Establish and name your board of directors that will represent the shareholders.
  • File your corporate bylaws with the local Secretary of State office. Your bylaws should include details like how often meetings are held, voting rights, and, if applicable, how shares of stock will be sold.
  • File IRS Form 2553, Election by a Small Business Corporation, at the appropriate time—if you need more help here, see the previous section.

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.

  • Be sure to include the names, addresses, and Social Security numbers of all shareholders or members.
  • Include each shareholder's number of shares or percentage of ownership and the dates they acquired them.
  • Have all of your shareholders consent to the election by signing and dating Column K on the form.

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.

 

Combining S corp status with an LLC

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:

  • Legally, your business remains an LLC, which means fewer administrative duties like formal meetings and reduced record-keeping requirements
  • In the eyes of the IRS, your business is an S corp, with the advantages of pass-through income and no double taxation
  • If your LLC business is very active, the S corp status can provide tax relief for your payroll taxes

Benefits of filing as an S corporation

There are several benefits to filing your taxes as an S corporation. Here are a few.

Avoid double taxation

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.

Less complex accounting rules

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

Transferrable ownership

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.

Is S corp status right for your business?

While operating under the S corp tax structure has many advantages, it may not always be the best fit for your small business.

Reasonable salary requirements

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.

State-specific taxes

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.

Strict requirements

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.

Talk to an expert

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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