How is S Corp Taxed?

What is an S Corp?

An S corporation is a type of business entity established under state corporation laws, separate from its shareholders. Prior to 1958, every corporation, regardless of size, submitted its own federal income tax returns and paid taxes on its earnings. This process, governed by Subchapter C of the Internal Revenue Code, led to these corporations being known as “C corporations.”

C corporations faced “double taxation” as they were taxed on their income, and when profits were distributed to shareholders in the form of dividends, it was taxed a second time as personal income for the shareholders. In response to complaints from small businesses about the challenges posed by double taxation, Congress introduced relief measures in 1958. Subchapter S was added to the Internal Revenue Code, creating the category known as “S corporations.”

An S corporation is essentially a corporation that chooses to be taxed according to the Internal Revenue Code’s Subchapter S. Our Los Angeles corporate attorney notes that the key distinction between a C corporation and an S corporation lies in their tax treatment as established by the Internal Revenue Code, with no differentiation in state statutes concerning corporations.

How does the IRS tax an S corporation?

LLC owners often wonder how is income from an S Corp taxed. The IRS taxes S corporations as flow-through structures, meaning that unlike C corporations, they do not pay federal income tax on their business earnings. Instead, profits, losses, deductions, and other tax-related items pass through to the owners of the business (such as shareholders). The S corporation submits Form 1120S, an information return, to the IRS, detailing each owner’s respective share.

The owners of the business are then responsible for paying taxes on their portion of the S corporation’s income, even if the funds are retained within the business and not distributed. This approach allows small businesses operating as S corporations to avoid the “double-taxation” that would occur if both the shareholders and corporation were taxed on distributed income. Thus, to be taxed as an S corp is seen as a plus.

Which corporations can be taxed as an S Corp?

Not all corporations are eligible to be taxed as an S Corp. Subchapter S imposes several limitations on corporations, which include the following:

1. To be taxed as an S corp, shareholders must be individuals, specific types of estates, trusts, or certain categories of tax-exempt organizations. For instance, a partnership cannot qualify as an S shareholder.

2. To be taxed as an S corp, the corporation has to be a U.S.-based entity with a maximum of 100 shareholders. (Related individuals may be counted as one shareholder.)

3. To be taxed as an S corp, the corporation may only issue one stock class, although variations in voting rights among common stock shares are allowed. Additionally, shareholders cannot be nonresident aliens.

Moreover, certain business types (e.g., insurance companies and financial institutions) are ineligible to be taxed as an S Corp, regardless of whether they meet other IRS requirements.

To maintain its S corporation status and be taxed as an S corp, a corporation must continuously meet these criteria. If the corporation does not do so — for instance, by issuing shares to more than one hundred people or to a partnership, corporation, or foreign citizen, or by creating more than one stock class — it will lose its eligibility for S corporation status.

S Corporation Advantages Compared to LLCs

Both LLCs and S corporations offer the benefit of flow-through taxation. However, in addition to being taxed as an S corp, opting for S corporation status can provide additional advantages, including:

1. Avoidance of self-employment tax on S corporation dividends, which is not the case for LLCs. This is particularly significant for employment-related taxes such as Social Security and Medicare. A shareholder in an S Corp who is also employed by the corporation is regarded as both an employee and an owner. By paying themselves an acceptable salary and treating the remaining profits as dividends, only the salary portion will be eligible for employment taxes, and not the dividend.

In contrast, in LLCs with disregarded entity status or those taxed as partnerships, an individual who works for the company is solely treated as an owner, and the full profit distribution will receive self-employment taxes. It is important to note that the IRS carefully monitors this practice and may take issue with salaries that it deems unreasonable, seeking to reclassify dividends as salary.

2. Easier conversion to C corporations compared to LLCs. Some startup owners have plans to eventually secure loans from external investors or private equity funds, who often prefer to invest in C corps. Additionally, some may have aspirations for an IPO, which S corporations cannot pursue due to limitations on the type and number of shareholders.

If owners desire flow-through taxation in the initial stages, they may opt to be taxed as an S corp rather than an LLC. This is because an S corp shares the same legal entity status as a C corp and only requires an IRS filing to alter its tax classification. In contrast, a limited liability company is a distinct legal entity from a corporation and must undergo conversion according to the rules outlined in state corporation and LLC laws.

S Corporation Disadvantages Compared to LLCs

Even though it is advantageous to be taxed as an S corp, there are a few drawbacks to choosing an S corporation, which include the following:

1. Less flexibility compared to an LLC. A lot of small business owners choose LLCs over corporations because they offer greater flexibility in both management structure and the allocation of management and financial rights. For instance, in an S corporation, profits need to be distributed in proportion to contributions of capital, whereas LLCs do not have such limitations.

2. LLCs offer flow-through taxation without restrictions under Subchapter S. A limited liability company can achieve flow-through taxation without being subject to the limitations that an S corporation faces regarding the type and number of shareholders, ownership interests classes, and other similar constraints.

If I want my business to be taxed as an S corp, what are the steps I need to take?

It is crucial to understand that an “S corporation” is not a standalone business entity type; it is a tax status that can be elected by a corporation. Therefore, the initial step for anyone looking to utilize the structure of an S corp is to establish a corporation.

The process of incorporation typically involves tasks such as selecting an incorporation state, choosing a corporate name, designating a registered agent, and preparing and submitting articles of incorporation to the Secretary of State or the equivalent state filing office.

It is important to note that state corporation laws do not differentiate between S corporations and C corporations. Thus, to be taxed as an S corp, an S corporation must adhere to all the requirements outlined in its home state’s corporation law. This includes responsibilities like filing annual reports, paying franchise taxes, conducting meetings, notifying the state of changes in registered agent or office, keeping corporate records, and more.

As a default, all corporations are subject to C corporation taxation. Therefore, after establishing your corporation, you must correctly file an IRS election to be taxed as an S corp. This can be accomplished by submitting Form 2553 to the IRS.

Making an S Corporation Election: Timely Action Required

For a corporation to be taxed as an S corp, it is imperative to promptly submit the necessary forms within a specific timeframe. If the election is not completed by the current tax year’s deadline, it will go into effect in the subsequent year.

Elections for a given tax year must be submitted early within that year, falling within a specified window. Specifically, the election must take place during the corporation’s tax year and on or prior to the fifteenth day of the tax year’s third month.

It is worth noting that for newly established corporations, the tax year typically does not commence on January 1. Therefore, it is advisable to file the election promptly to alleviate concerns about meeting the deadline for the initial tax year.

Once a proper S corporation election is made, it remains effective for all subsequent years unless voluntarily terminated by you or by the IRS due to a violation of S corporation rules. There is no need to re-elect every year to be taxed as an S corp.

Additionally, unanimous consent from all shareholders is essential for the election to be considered valid. Without this unanimous agreement, the election will not be recognized and the company will not be taxed as an S corp.

In Summary

An S corporation is a type of corporation that allocates its expenses, income, and losses to shareholders based on their ownership stakes in the company. Opting for S corporation status can lead to federal income tax savings, with many states also treating S corporations as pass-through entities for state income tax purposes.

Furthermore, for corporations where the owners are actively involved in the business, choosing S corporation status can result in savings on self-employment taxes for the owners.

Ultimately, the selection of a business entity type depends on various considerations for a small business owner. If it will help your business to be taxed as an S corp, it is recommended to consult with your advisor for further guidance.