If your business is a corporation, you’re already aware that March 15th is the most critical tax deadline of the year. But March 15th is an important deadline for another reason…it’s the deadline for electing S Corporation status.
Choosing the right business structure is a significant issue, one you’ll want to consider carefully from all angles. The S Corporation is a popular way for small businesses to optimize their tax treatment and with the S Corp election deadline approaching, it’s a good time to examine this business entity.
If you’re launching a new business or are considering switching your corporate status, read on to learn if the S Corporation is right for you.
What is the S Corporation?
Let’s start at the beginning. An S Corporation begins as general, for-profit C Corporation. After the corporation has been formed, it can elect ‘S Corporation Status’ by filing Form 2553 with the IRS in a timely manner (we’ll cover deadlines in more detail below). With this election, the company is now taxed as a sole proprietor or partnership rather than as a separate entity like the C Corp. This means that corporate profits and losses are “passed-through” and reported on the personal income tax returns of the shareholders. That’s why the S Corp is known as a ‘pass-through entity.’
What are the benefits of the S Corporation?
The main reason to elect S Corporation status is to avoid double taxation. A C Corporation is a separate tax payer that files its own federal and possibly state tax returns. Any profits are first taxed in the Corporation’s tax return. Then if the Corporation decides to take that profit and distribute dividends to shareholders, the dividends are taxed again (this time, on each shareholder’s personal tax statement).
As an S Corporation, the company pays no income tax. The profit is distributed to the shareholders as a dividend. Of course, bear in mind if a shareholder also works in the business, they must be paid a reasonable wage for their activities. And these wages are subject to the personal income tax rate (in other words, you can’t just compensate yourself in dividends).
What are the drawbacks of the S Corporation?
The S Corporation entails extra structure, formalities, and compliance obligations for the solo entrepreneur with a “payroll of one.” If you incorporate as an S Corporation, you need to set up a board of directors, file annual reports and other business filings, hold shareholder’s meetings, keep records of your meeting minutes, and generally operate at a higher level of regulatory compliance than your business might need or want to deal with. Instead of dealing with all this red tape and complexity, forming an LLC might give you greater simplicity and ease of doing business. And, the LLC still gives you the pass-through tax treatment just like the S Corp.
The other downside of the S Corp is its strict allocation of income. In an S Corporation, each owner/shareholder must share in the income in direct proportion to their ownership. If you and a partner each own 50% of the business, you each will be taxed on 50% of the profits, regardless of any other agreements you might make about splitting up the profits. In contrast, an LLC offers more flexibility when it comes to allocating income amongst the owners.
Who can’t form an S Corporation?
The IRS places certain restrictions on S-Corps, including:
- An S-Corp cannot have more than 100 shareholders.
- All shareholders in an S-Corp must be individuals (not LLCs or partnerships) and legal residents of the United States.
- An S-Corp can have only one class of stock, so all owners must share equally in terms of profits and losses based on their percentage of ownership.
When is the S Corp deadline?
If you have an existing Corporation (C Corp) or LLC, March 15th is your deadline for filing IRS Form 2553 with the IRS and electing S Corporation status for this tax year and forward. In other words, if your corporation/LLC existed on Jan 1, 2011, you need to file form 2553 by March 15, 2012 in order to have your S Corp in effect for the 2012 tax year. However, if you form a corporation or LLC on June 1, 2012, then your S Corporation deadline is August 15 (75 days from June 1).
If you miss the deadline, you’ll most likely be taxed as a C Corporation for the current tax year, and then your S Corp election will be effective for the following tax year. The IRS may give you a pass if you can show that your failure to file on time was due to ‘reasonable cause.’ Of course, no one wants to be at the mercy of the IRS, so play it safe and get your form in on time.
Your choice in business structure will ultimately depend on all the unique aspects of your business. But regardless of which business type you choose, taking a serious look at your legal structure is essential to set your business up for success.
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Coming from someone in the Accounting and Tax Services industry this section is the most critical: “they must be paid a reasonable wage for their activities.”
Most S-Corps we see that have little to no profit usually do not need to worry about this, however, when the profits are more than $25k then it becomes more complicated and will depend on the type of business and ratio of gross revenue to net income as to what the “reasonable wage” is for tax purposes. Then again, we always say that audits are a game of chance, either they’re selective(randomly chosen) or red-flag(gross violations of the tax laws) and there’s no way to tell whether or not you will get audited. Ultimately, the decision to draw a salary is up to the business owner, but it takes a good tax service to make sure they make the RIGHT decision.
Thanks for the info, but I don’t think I’ll be changing to an S-corp anytime soon. Just adds too much complexity.
@Robert- if you’re already setup as an LLC Partnership or Sole-Proprietor then it might not be worth it to set up as an S-Corp, however, if you’re looking at getting hit with “self-employment” taxes and would prefer to make your own retirement funding plans(instead of being forced to by the gov’t) it’s worth it to fill out the quick 2 page Form 2553(or have a professional do it for you if you’re uncomfortable with it).
This article states that “dividends” from an S Corp are taxed at the 15% dividend rate. I don’t believe this is correct as all income from an S Corp is “passed through” to the shareholders personal income tax, whether the income is paid out as a dividend or retained in the corporation, and thus taxed at whatever the personal income tax rate may be. This is one of the drawbacks of an S Corp if the corporation makes too much money.
The profits come back on the personal return on a K1 and they are taxed at the person’s regular tax rate. However, they bypass paying FICA taxes that would be paid if this was earned income. If the income was paid as wages the S-Corp would have to pay their share of FICA taxes (7.65%), and the employee would have to pay the other share of FICA taxes (also 7.65%). When these are paid as dividends there is a savings of 15.3%.
I don’t believe that S Corp earnings are ever taxed as dividends- always personal income whether distributed or not.
Most people that are ready for the structure of an S Corp have been advised by Lawyers and Accountants to do so. This is not a change that you take upon yourself to minimize taxes, you might get stuck in a conundrum of legality and fees just trying.
John Richmann EA
There’s a state taxation aspect to this issue, too, especially with state unemployment taxes. At least in Illinois, shareholders of S Corps must pay “contributions” (as this tax is called) to the Department of Employment Security. Sole proprietors and sole members of LLCs don’t have this burden. The default contribution rate that new businesses must pay is often high enough that this tax alone can jeopardize a start-up’s success.
I currently have an s corp. it was filed late therefor it became an s corp on January 1,2012. However the corporation went into effect (as a c corp) in July of 2011. I was wondering how to file.. Should I file a regular 1120 for July 28.2011-dec 31,2011 then file an 1120s for the full year of 2012? The deadline I believe is march 15th 2013 to file my 1120s for tax year 2012. I am already late on my 1120 for 2011 but then again I am not sure how to file in my situation. I filed an 1120s for the fiscal year (July 2011-June 2012) and it was rejected. I think this is because in the middle I became an s corp. can someone please let me know what to do? Thanks!
I want to add a description to my corporation. I am an s Corp.
Your statement about S Corporate dividends being taxed at 15% does not seem correct. Do you have an actual tax code section. We can’t seem to find one. Also, while I didn’t look at your whole site, you may want to have a Circular 230 disclosure statement on it regarding any of your tax advise.
Thank you very much for taking the time to read my post and for commenting. I am revising this article to remove that sentence to avoid any future confusion.
Great article. Thanks for the info, you made it easy to understand. BTW, if anyone needs to fill out a form 2553, I found a blank form here http://goo.gl/C0cEs4. This site PDFfiller also has some tutorials on how to fill it out and a few related tax forms that you might find useful.
Hi Paul –
No problem, thank you for reading and commenting on my post!
Thanks for sharing that resource!