Considering the S Corp Election for your LLC?
08/31/2015
Wage Optimizer
The S Corporation is a tax status election that conveys certain benefits over “regular” type LLCs: sole proprietorships and partnerships. Namely, the most-often cited tax benefit is the ability to classify some of the business’s net profit as distributions of profit to officers of the corporation. These distributions are not subject to payroll taxes, which can result in significant tax savings for employee owners.
Further, unlike the C Corporation, the S Corporation is not liable to double taxation at both the corporate and individual level. Read on to learn more about whether the S Corp election is right for your small business.
The Basics – How to Elect S Corp Status
First off, it is important to understand that the S Corporation election is a tax status election only, and does not change the legal status of your business entity. Hence, if you currently have an LLC, your legal entity and its protections will not be altered when you elect to file under Subchapter S (forming what is commonly known as an S Corporation).
Qualifications and Filing
The IRS has many rules limiting who exactly is eligible to file under Subchapter S. Generally, the qualifications for a corporation to elect S Corp status are as follows:
- The corporation must be domestic.
- Corporation shareholders must be individuals, estates, or certain trusts.
- The corporation may have no more than 100 shareholders.
- The corporation must have only 1 class of stock.
- The corporation must not have any nonresident alien shareholders.
- The corporation must either make the election in the first 2 months and 15 days after the beginning of the year the election is to take effect or any time during the year preceding the election taking effect.
There are additional qualifications as well, limiting specific non-eligible entities and certain tax-years. For more information on S Corporation eligibility, see IRS Instructions for Form 2553. Use IRS Form 2553 to file for S Corporation status according to the instructions.
Benefits of the S Corporation
The primary benefit of electing S Corporation status is saving on payroll taxes for employee owners of the S Corporation. Business Expenses are treated much the same as in other tax entities (see our post on Business Expenses), and employee owners who provide services to the company must be compensated in wages with what is known as “reasonable compensation” (see our post on how to determine Reasonable Compensation). However, once employee owners have been paid a reasonable annual salary, business income can be passed through to shareholders without payroll tax consequences, in many cases saving as much as 15.3% in taxes on these payments. Use WageOptimizer.com’s reasonable salary calculator to investigate the possible tax savings for your business. S Corporations may also further avoid payroll taxes by electing to distribute pre-tax income of up to 25% of total company W-2 wages and compensation into a profit-sharing plan (limited to $52,000 for 2015). Some additional benefits to S Corporation status include the ability to save on gifts to lower tax bracket individuals (see here for more on this) and the aforementioned lack of double taxation on corporate income that is common for the C Corporation.
Disadvantages
Disadvantages are primarily driven by higher costs associated with formation, ongoing accounting expenses and tax preparation fees. There is also generally heightened IRS scrutiny when it comes to the activities of S Corps. Also, though S Corporation Income is protected from double taxation at the federal level, many states do not confer the same benefit. Additionally, there are consideration regarding less flexibility in stock structure and distribution of profits to multiple owners. It is recommended that any company considering electing Subchapter S status seek the advice of their tax lawyer prior to making the election. For a more exhaustive discussion of disadvantages, please see Inc.com’s article “S Corp vs LLC”.
Conclusion
Electing an S Corporation can be highly beneficial to many small business owners in providing for significant payroll tax savings on some portion of their business income. Generally, corporations with a single shareholder who provides substantial services to the company and who is much more productive economically than a likewise employed person will see the greatest tax benefits from electing to file under Subchapter S. If you are considering electing S Corporation status for your small business, use WageOptimizer.com’s calculator to evaluate whether the tax savings are substantial enough to make the election right for you.
Additional Resources
Turbotax: How an S-Corp Can Reduce Your Self-Employment Taxes
IRS: Small Businesses & Self Employed/S Corporations
SBA: Choose Your Business Structure/S Corporation
Forbe’s: S Corporation SE Avoidance Still A Solid Strategy
DOL: Profit Sharing Plans for Small Businesses