What is an S-Corp?
An S-Corp is a corporation that has received the Subchapter S designation from the IRS. A business must first be chartered as a corporation in the state where it’s headquartered and then file to be considered an S-Corp.
According to the IRS, S-Corporations are “considered by law to be a unique entity, separate and apart from those who own it.” This allows for a limit on the financial liability for which an owner (also known as a ‘shareholder’) is responsible.
Key Features of an S-Corp
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Pass-Through Taxation: The S-Corp has the ability to have profits and losses pass through to the shareholder’s personal tax return. Therefore, the business itself is not taxed , only the shareholders are.
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Reasonable Compensation Requirement: Any shareholder who works for the company must pay him or herself “reasonable compensation.” Essentially, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as ‘wages.’
Pros and Cons of the S-Corp
Benefits
One of the best features of the S-Corp is the tax savings for you and your business:
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Members of an LLC are subject to employment tax on the entire net income of the business.
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Conversely, only the wages of the S-Corp shareholder who is an employee are subject to employment tax.
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The remaining income is paid to the owner as a ‘distribution,’ which is taxed at the same rate as the rest of the shareholder’s income.
Additional benefits include:
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The benefits that shareholder/employees receive can be written off as business expenses.
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An S-Corp allows the business to have an independent life separate from the shareholders.
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If a shareholder dies, leaves the company, or sells his or her shares, the S-Corp can continue doing business relatively undisturbed.
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Maintaining the business as a distinct corporate entity helps define clearer lines between the shareholders and the business, improving the protection of the shareholders.
Potential Drawbacks
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As a separate structure, S-Corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers, and records maintenance.
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There will be a greater number of forms required by the IRS for an S Corp.
Combining the Benefits of an LLC with an S-Corp
There is always the possibility of requesting S-Corp status for your LLC. Your tax professional can advise you on the pros and cons.
Important Filing Information
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A special election must be made with the IRS to have the LLC taxed as an S-Corp using Form 2553.
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This must be filed before the first two months and fifteen days of the beginning of the tax year in which the election is to take effect.
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Some late elections are allowed by the IRS under special circumstances.
Frequently Asked Questions
What are the main tax benefits of an S-Corp?
An S-Corp allows income to pass through to shareholders, meaning the business itself isn’t taxed. Only the shareholder’s wages are subject to employment taxes, while remaining profits are treated as distributions taxed at the shareholder’s individual rate, often resulting in tax savings.
Can a single-owner business become an S-Corp?
Yes, a single-owner business can elect S-Corp status if it first forms a corporation or LLC and then files IRS Form 2553 to opt in. Even as a sole shareholder, the business must follow all S-Corp rules, including paying reasonable compensation.
What is “reasonable compensation” for S-Corp shareholders?
Reasonable compensation refers to a fair market salary that an S-Corp shareholder-employee must pay themselves for work performed. The IRS requires this to prevent tax avoidance through excessive profit distributions.
How is an S-Corp different from an LLC?
While both protect owners from personal liability, an S-Corp provides potential payroll tax savings. LLCs have fewer formal requirements, but S-Corps can offer financial advantages if managed properly and if shareholders draw reasonable salaries.
What is the deadline for filing S-Corp election?
To be taxed as an S-Corp for a given tax year, IRS Form 2553 must be filed within two months and fifteen days after the start of that year. Late elections may be accepted under certain IRS-approved conditions.