The US Tax code and business structures might seem complex with most people knowing little about taxes along with fundamental business structures.
The main business structures are:
- Sole proprietors
- C corps
- S corps
Each structure has its own rules, regulations, and tax provisions. Therefore, it’s wise to know the fundamentals of each structure and which one is right for your business needs. This post will serve as a guide to help understand an S Corporation Election (one of the more common business structures) and fundamental S corp tax rules.
What is an S corporation election?
An S corp is a business structure you’d use if:
- You have less than 100 shareholders
- Offer only one type of stock
- Want to avoid double taxation.
It’s similar to a hybrid between partnerships and C corps. It allows the business to be incorporated like a C corp, but an S corp avoids double taxation. S corps are taxed like partnerships because these structures both aren’t taxed at the corporate level. Instead, they pass income, deductions, and expenses to shareholders, who are then taxed.
There are many types of stock, like preferred stock, class A shares, and class B shares. An S corp would only offer a standard common stock, without any special features. Other types of stock have special features like having a debt component (preferred stock) and more voting power (class A shares have more voting power than class B shares).
An S corporation election is good for businesses that want to stay somewhat small. Unlike a C corp, S corps aren’t publicly traded and don’t have thousands of shareholders. S corps can be a great structure for businesses that want to be taxed like a partnership. Partnerships and S corps are taxed as flow-through entities, meaning the organization doesn’t pay taxes on a federal level. However, the partners and members receive the income, deductions, and credits on a pass-through level.
Conversely, a large C corp would have to pay taxes on both the federal level and the members would have pay taxes on the net earnings as well (a.k.a DOUBLE TAXATION).
Check out our guide to the LLC Taxes and LLC Tax Returns
Who should use an S-corp?
There are certain requirements that must be met to when choosing an S corporation election. For instance, an S corp can be an individual, tax-exempt organization like 501(c) nonprofits and certain trusts as well as estates. Corporations, resident aliens, and most insurance along with financial institutions don’t qualify as an S corp.
One of the most important rules to consider is the resident alien test. Per the IRS, a person can be considered a resident alien, even if he or she is not a permanent resident or U.S. citizen, provided that he or she has been in the US for at least 31 days in the current year and a total of 183 days over the past three years. You can use the IRS’s substantial presence test to follow this rule. There are many stipulations of this test, but keep in mind that:
- It doesn’t include staying in US territories like Guam or Puerto Rico
- The more specific roles of the 183 day/3-year test which are:
- Every day he or she was was present in the current year,
- One-third of the days he or she was present in the first year before the current year, and
- One-sixth of the days he or she were present in the second year before the current year.
Pros of an S Corporation Election
- Establishes credibility with employees and customers: Going from a sole proprietorship to an S corp shows others that your business is growing and that you’re formally committed to the company, which establishes trust with others.
- Avoid federal income tax: S corps don’t pay tax on a federal level, but instead, pass income, credits, deductions to shareholders. Not only does this save on taxes, but it can make it complex accounting decisions like transferring interest and adjusting the basis easier.
- Salary vs. dividends: Shareholders can be employees that earn salaries and can even receive corporate tax-free dividends if the amount doesn’t exceed the stock basis. If it does, then these amounts would be taxed as capital gains. Having the discretion to determine which distributions are salary or dividends can help you lower your self-employment tax.
- Can offer shares in your company without the complexity of a C corp: Offering shares in your company to your employees can be a great way to motivate them. Stock or equity-based compensation is becoming a very popular way to offer performance-based awards. S Corps can help you do this by offering one class of stock to 100 shareholders or less. Keep in mind that these will be shares of a private company and it could be wise to become a C corp if you want to have an IPO, or go public.
Cons of an S Corporation Election
- Money and time costs: S corps are more simple than other structures, but still require time and money to establish. For example, each S corp must pay the following fees: incorporation, reporting, franchise tax, accounting, and legal. These fees can also vary state to state with California being one of the more expensive states. The minimum expense usually starts out at $800 and can go up to $4,000 when including other expenses. Fortunately, these fees can be deducted as a cost of doing business.
- Besides these fees, S corps must register with their state, fill out the proper paperwork (sometimes with the guidance of an attorney), obtain a registered agent for the business, and pay compliance fees.
- Higher IRS scrutiny: As mentioned earlier, many S corps disguise wages as corporate dividends to pay fewer taxes. The IRS is very aware of this practice and can heavily scrutinize these structures. Therefore, it’s wise to pay yourself and your employees’ reasonable salaries.
- Compliance: S corps have a lot of compliance standards which apply to the election, consent, notification, stock ownership, and other filing requirements. Any noncompliance could cause the S corporation to become terminated. Luckily, this rarely occurs as you can avoid this fate by quickly correcting these errors.
- Limited growth: S corps are great since you get the best of both worlds from partnerships and C corps. Well, what if you want to grow your company and become publicly traded? Unfortunately, S corps can’t do that and C corps have more growth potential in this regard.
Important S Corporation Election Documentation/Tax Forms
S Corps aren’t the most complex business structure, but they’re not as simple as a single LLC. As mentioned earlier, it takes a certain amount of time and money to properly establish one. Let’s take a look at some important documentation associated with S Corps!
It might seem counter-intuitive, but you and your partners must first elect the business as a C corp prior to becoming an S corp. C corps are larger than S corps, which is why this step might not make sense. Once this step is complete, sign form 2553 to convert the business to an S corp. This form must be filed either 75 days from the start of the new year or within 75 days from the creation of your business.
The IRS will notify you in writing if your S corp has been accepted. Then, you can add incorporated or inc. to your business’s name. Keep in mind that you don’t need an attorney to draft any documents to establish an S corp, but it could be smart to have one on retainer for legal advice. Also, this form is a federal form, meaning that each state has its own unique requirements, which you can learn more about here.
Articles of Incorporation
Like form 2553, the Articles of Incorporation are fundamental documents needed for an S corporation election. Articles of Incorporation are needed for creating C corps as well and other structures like LLPs along with LLCs require similar documentation.
Each document changes slightly per business structure, but they generally require the following:
- The business’s name and location
- Shareholders, directors, important officers, and influential parties like board members
- The business’s mission, purpose, and value statements
- The amount of stock along with the types of stock that will be distributed
Like form 2553, each state has its own unique requirements for filing, fees, procedures and more! Also, you don’t need an attorney to draft these documents, but it’s wise to consult one.
Taxes are a very important part of any business, especially for an S corp. S corp owners must properly fill out Form 1120S which will record important information like income, deductions, expenses, payments to contractors and more. This form is similar to Form 1120, which is used for the taxation of C corps. One easy and subtle way to distinguish these forms is that Form 1120S has the letter S for S Corp. When filling out form 1120S, you need to have your date of incorporation, business activity code, employer identification number (EIN), income statement, accounting method, and a list of your products or services.
Out of this list, it’s really important to pay close attention to the business activity code and contractor payments. A business activity code tells the IRS, what industry you’re in, which will help you stay organized. Also, you must keep track of payments that you distribute to contract workers, also known as 1099ers. They’re called 1099ers because you must report their income (if it’s above $600 per year) on a form 1099. Then, the contractor must pay taxes on this income.
You can access form 1120S via the IRS.gov website. Clearly, this form is complex and requires many different fields depending on your situation. A smart move could be to gather your required documentation and hire a competent accountant to prepare this form. Also, you should know that form 1120S is due by March 15 of each year. Form 1120S can be paper filed or filed electronically as well. This form can also be submitted as late as September 15 if you decide to file an extension.
Form K-1 is used in many tax situations from reporting distributions from trusts, partnerships, estates and of course S corps. This form is associated with an income source that generates pass-through income for its beneficiaries. S corps use K-1s to determine each shareholder’s portion of the income, credits, losses, and deductions. Then, each individual shareholder will include K-1s in their own tax returns.
K-1’s are tricky forms and are infamously known for arriving late. Thus, these forms are one of the most common causes of filing an extension. These forms are due by mid-March each year, giving the taxpayer only a month to complete their taxes. Also, each form has unique sets of income and expenses that must be used to adjust other tax forms like Schedule A, Schedule B, and Schedule D.
These adjustments can make taxes even more complex since they can include rental income, bond adjustments and various types of dividends. In some cases, they can put a taxpayer in the AMT or alternative minimum tax. The AMT was created back in the 1960s to ensure that everybody, including the rich, paid their fair share of taxes. Taxpayers in AMT would lose some deductions and have to pay unnecessary taxes.
S Corporation Election Additional Resources
- Best tax treatment for your company calculator.
- Per state, S Corp and other business structure requirements.
- S Corp vs Sole Proprietorship tax calculator.
- IRS Forms: K-1, 1120S, 2553
By reading this article, you should know about the fundamentals of an S corporation election. Taxes and business structures might seem complex, but it’s wise to know the fundamentals of your business structure. This will allow you to maximize tax benefits, satisfy your custom business needs, and stay in compliance with the tax code. We hope that this article added some clarification on this important topic and that it will prepare you for business success.
Disclaimer: We are not affiliated nor endorse any of the associations mentioned here. Also, this post is general education, not tax advice. Consult a CPA or tax adviser for tax advice.