Choosing a business structure is an important, and often confusing, decision for any small business owner. With the S Corporation election deadline approaching (March 15, 2016 for existing businesses), this is a good time to explore the advantages of electing S Corporation tax treatment to see if it’s right for your business.
Keep in mind that everything written here should be taken as general information and is not a substitute for advice from a tax advisor or CPA who’s familiar with the specifics of your situation.
What is an S Corporation?
An S Corporation refers to a special election that is made with the IRS that gives a business pass-through tax treatment for federal tax purposes. This means that when a business elects to be treated as an S Corporation, it does not pay federal taxes at the corporate level. Instead, any profits or loss of the business are passed through to the shareholders, who then report that profit/loss on their personal income tax returns.
The important thing to realize is that an “S Corporation” isn’t actually a business structure in and of itself. When you first launch a business, you need to set up your business structure, either a corporation or LLC, with the state. Then, if you choose, you can apply for S Corporation tax treatment with the IRS.
What are the main S Corporation Benefits?
The primary reason why businesses elect S Corporation status is to avoid double taxation when structured as a corporation. With a traditional C Corporation, here’s a simplified look at how taxes work. The Corporation is a separate entity that needs to file its own federal tax returns; this means the business pays taxes on any profits for the year. Then, if the business decides to take those profits and distribute dividends to its shareholders, the shareholders are taxed on the dividends on their personal tax return.
For business owners looking to take extra profits out of the business, a C Corporation can mean double taxation: the business is taxed on the profits and shareholders/owners are taxed on the dividends. When a company elects S Corporation tax treatment, it eliminates the first part of the equation: the business is no longer taxed on its profits.
This may sound a lot like how a partnership or sole proprietorship is taxed. It’s true that the partnership, sole proprietorship, and S Corporation all enjoy “pass-through” tax treatment. But, there is one difference when it comes to self-employment tax and owners working in the business.
With the partnership or sole proprietorship, a partner/owner typically needs to pay self-employment tax on his or her share of the business income. However, with S Corporation election, the S Corporation owner doesn’t pay self-employment tax on the pass-through income/distributions from the business.
An LLC can choose to be taxed either as a partnership or S Corporation — and many LLC owners can benefit from electing S Corporation status to minimize their self-employment taxes. Keep in mind that if you are working in the business, you will need to pay yourself a proper salary for the work and this salary will be subject to self-employment/FICA tax. If you’re interested in this strategy, you may want to speak with a CPA or tax advisor to avoid trouble, since the IRS does check to make sure S Corporation owners aren’t trying to pay themselves too much via distributions instead of a salary.
Who can Qualify to be an S Corporation?
Not every business can qualify for S Corporation status, as the IRS places several restrictions, including:
Shareholders of an S Corporation must be U.S. citizens or permanent residents. This also means that an LLC or partnership cannot be a shareholder of an S Corp.
An S Corporation cannot have more than 100 shareholders.
If you fit the criteria to be an S Corporation and are interested, be aware that there is a deadline to apply with the IRS. If you are forming a new business, you have 75 days from your date of incorporation to file your S Corporation paperwork (it’s IRS Form 2553).
If you have an existing business and want to elect to be an S Corporation, you need to file within 75 days of the start of the tax year. So, an existing business would need to file by March 15, 2016 in order to be considered an S Corporation for tax-year 2016.
Whether S Corporation election makes sense for your business will ultimately depend on the unique aspects of your finances and situation. Take some time to research the differences, or speak with a CPA, and be sure to get your paperwork in by the deadline.