Many small businesses hear of S Corp Election but not many put pen to paper and take action. Why? Registration can be complex, especially for LLC’s with a variety of members. Business restructuring is a lofty goal amidst the daily grind. So we are here to make the process painless with this S election guide.
In this article we will answer:
- What is an S Corp election?
- What are the benefits of S election?
- Examples of tax savings with an S Corp election
- Paperwork requirements and registration process with S Corp Election Form 2553
What Is An S Election?
An S Corporation election is not a type of company, but a Federal tax election. An S election is optimal because it is taxed more favorably than the original business structure (LLC, Corporation, Partnership). The largest savings occurs by not paying a portion of self-employment tax. These taxes are passed through the business entity to the shareholders income taxes.
Shareholders report the flow-through of income or losses on their personal tax returns. They are assessed tax at their individual income tax rates. So when corporate income is distributed to the shareholders, the distributions are tax-free, avoiding double taxation so typical of C Corporations.
With one the condition, the shareholder needs to have basis to take the distribution. If a shareholder does not have basis, the distribution may be subject to additional tax as a dividend. There a three ways a shareholder can receive distributions:
- A taxable dividend
- A gain from sale of corporate stock
What is a Reasonable Salary for S Corporation Officers and Owners
This is a highly debated item with little guidance from the IRS. We recommend using comparable salaries on the market. Look on websites like Glassdoor or indeed, to find the average salary for the position in your area. Keep in mind, your actual business revenue and income is also factored in.
IRS Reasonable Salary Rule
To the extent the amounts are reasonable compensation for services rendered to the corporation.
For Example: Say you’re a CEO of a tech start-up, and the average salary of a tech startup CEO is $400,000. Your company may not have the funds to support that salary. So it wouldn’t make sense to pay or file according to that average salary. If your company is NOT making money, the IRS will NOT object to you not paying yourself. As soon as the company starts making a profit, you need to pay yourself reasonable compensation.
Some owners try to avoid payroll tax, by solely giving themselves corporate distributions—that is illegal. The IRS has no tolerance for corporations that disguise employee salaries as corporate distributions. They can and will reclassify your distributions as an owner salary. Plus they will collect self employment taxes, if it is deemed your salary was not reasonable. It is always best to speak to a tax professional about your particular situation, to discuss what is appropriate.
How Does An S Corp Save On Taxes?
S Corporations only owe self-employment tax on what is paid out as wages. You would not pay those taxes on your pass through income. So with an S Corp election you save on Social Security and Medicare. This is the valid for all LLC structures: sole proprietor, single member disregarded entity, or partnerships.
Without the s-election, you would pay a 15.3% tax rate, on the entirety of net income, for Medicare and Social Security. The rate is 15.3% because as a self employer, you pay both the employer and employee portions of taxes. In comparison, when you work for someone else you only pay 7.65% as an employee. So on your taxes it appears you are an employee of a company, in reality you are working for your own business.
S Election is Recognized at the State Level
For most states the Federal s election is recognized at the state level. Although businesses may need to file extra paper work to get the same s-election tax treatment. It is always good to check local state regulation to see if your company has additional filing requirements. Here are the state tax authorities that do NOT recognize the federal S Corp election:
- District of Columbia
- New Hampshire
- New York City
Who can be an S Corp Owner/Shareholder?
Unfortunately S election excludes non resident alien owners/shareholders. If a company has a direct owner receiving distributions, who is non resident alien, they risk a revocation of their S Corp status. Although, non resident aliens can have indirect ownership by being an ESBT trust beneficiary. This is a great solution for S corporations wanting foreign investment. As well as, nonresident aliens applying for residency in the near future.
S corporations CAN have a resident alien as a shareholder. This is someone who holds permanent residence within the U.S. A resident alien is either a lawful U.S. resident, or a person who qualifies via the “presence test.” These residents are legal taxpayers and the IRS can easily track S Corp income and holdings.
Why Corporations Should Change to S-election?
Corporate taxes are always in flux depending on the legislation. The newly proposed taxes on C Corporations could mean a tax rate of 25%-28%. This is up from the 21% rate approved with the Tax Cuts and Jobs act in 2017. Not to mention the highest tier tax rate for capital gains is under scrutiny.
What does this have to do with s-election? The S corporation structure could be far more appealing to companies looking for ways to save. With pass through tax rates near 20%, and income in the form of wages and distributions. This structure has a lot to offer companies who have less than 100 shareholders. Note: if a C corp restructures to an S corporation, certain Accumulated Earnings & Profits (AE&P) from when it was C Corp, will be subject to tax.
How Much Do You Save As An S Corporation
Get concrete numbers before going all in. The math in this example is for information purposes only. Actual numbers are complicated and vary for each business. Always consult with your tax accountant before making tax decisions. Here is an example of how much you save by being an S Corp:
Example of S-Election Tax Savings
You are running a business as a single tax filer. At the end of the year, after all your expenses, your net income is $100,000.
How Much Tax Would you Pay as an LLC?
- With the standard deduction of $12,550 your taxable income = $87,450.
- You are right over the 24% tax bracket, so total Federal Income Tax = $15,009
- You are also responsible for Medicare/Social Security, at a 15.3% tax rate = $14,000
- Note: As a self employed individual there is a 7.65% deduction available if your total net income is more than the social security threshold = $137,700. For this example the net income is below $137k so we use 15.3% tax rate.
- Total tax liability = $29,000
Total Take Home: $100,000 Gross Income – $15,009 Federal Taxes – $14,000 Self Employment Taxes = $70,991
How Much Tax Would you Pay as an S Corp?
- S election means you had to pay yourself a reasonable salary = $40,000.
- Plus these expenses related to payroll:
- Payroll System = $500/year
- Federal and State Unemployment Tax – This is paid by the employer (you in this case) to the state and federal government for unemployment insurance. It varies by state, so for our example we will use 4% as the average rate = $1,600
- Workers Compensation – Many states don’t require single shareholders of S Corporations to have this. For this example you have to get it, and we’ll use $20 per month as an example number = $240
- The company also pays your portion of Social Security and Medicare = $3,060
- Filing paperwork for end of year taxes as an S corp is a typical expense = $600/year.
- Business expenses in summary:
- Payroll System = $500
- Unemployment Insurance = $1,600
- Workers Comp = $240
- Company Portion of Social Security and Medicare = $3,060
- S Corp annual tax maintenance = $600
- Total = $6,000
- Your new business income would be ($100,000 net income – $40,000 salary – $6,000 additional expenses) = $54,000
- Total Gross Income ($40,000 salary + $54,000 business income) = $94,000
- With the standard deduction of $12,550 your taxable income = $81,450
- You meet the 22% tax bracket, so total Federal Income Tax = $13,668
- Self employment tax for Social Security and Medicare $3060 was taken out of your wages via payroll and $3060 was paid by your company = $6120
Total Take Home: $94,000 Gross Income – $13,668 Federal Taxes – $6,120 Self Employment Tax = $74,212
Income after Taxes: LLC vs S Corp Example
The chart below shows a side by side income comparison of the above example. With the S election there is a savings of $3,221. The example doesn’t factor in the additional QBI deduction an S Corp can take advantage of, which gives shareholders even more savings. Bottom line, the more money you earn under an S corporation election, the more money you will save.
What are the Disadvantages of S Corp Election?
S election holds many tax advantages for small business owners looking to incorporate. However there are 5 Disadvantages of an S Corporation election:
- They are inflexible with the allocation of income to shareholders. In contrast to a Partnership or LLC where you can set any amount of income on a K-1, that is more or less reflective of the percentage of ownership. An S corporation must follow IRS approved formulas for calculating income.
- As stated above, non resident alien ownership is not allowed. Everybody that owns an S Corporation has to be a U.S. resident.
- It is NOT an ineffective election for founders seeking investment. The shares are limited to 100, and you cannot have different classes of shares.
- S election has stricter management requirements, and you have to issue owners salaries. That is not a requirement in Partnerships and LLC’s.
- Any benefits, including health insurance, are considered income and must be reported on a W-2.
How to Register for S Corp election
For the S Corp tax election you have to file Form 2553. Per the instructions provided you can mail or fax it to the IRS. We prefer fax it is the faster method. In our experience, you can do a late S election and still get approved (although it is not guaranteed). It is best not to do it too close to the year end because you might not get a timely approval. You need to know if you should be accounting and filing as an S corp.
Dues Dates for Form 2553
- Form 2335 is due no more than 2 months and 15 days after the beginning of the tax year of election.
- If you are filing a late S corporation election form, you need to file within 3 years and 75 days.
How to fill out S-corp Election Form 2553
Below is an explanation of key items on form 2553. The form is split into two Parts. Most companies making s-election filings will only need to fill out Part I. If your business enters Part II territory, a consultation with a tax advisor is highly recommend.
Form 2553: Part I
- E – This is for calendar tax year filers—most companies are. It means your accounting runs on the calendar year (January 1st – December 31st). Select 01/01 for the month and year you are making the election.
- F – To more accurately reflect business-purpose and income, you will indicate a different accounting year here.
- G – Select this box if you are treating your entire family as one shareholder, and doing so won’t exceed the maximum of 100 shareholders. If you are treating each member of your family as individual shareholders, include them in items J, K, L, M, and N.
- I – If you did not meet the deadline requirements, provide a statement as to why you still qualify to request an S election. The IRS requests reasonable cause for a late s election filing.
Examples of situations where the IRS has found reasonable cause include: (1) the entity’s responsible person failed to file the S election; (2) the entity’s tax professional failed to file the S election; and (3) the entity did not know it needed to affirmatively file an S election. – Foster Garvey
Form 2553: Part II
- O – This section pertains to selections 2 or 4 made in F. You adopt, retain, or change to follow a fiscal year ending in a specified month, or a 52-53-week year ending in certain month.
- P – Most businesses filling out Part II will select this item for automatic approval by the IRS. For Natural Business Year, you must provide a gross receipts statement of the most recent 47 months. Select the Ownership Year to change to the same tax year as shareholders holding more than 50% of business shares.
- Q – For a change in tax year that does NOT fall under the automatic approval of business-purpose, fill this out. Most will opt for Q2 and item R for a section 444 request. Note: if you select Q1 you will be charged a fee of $6200
- R – Make a section 444 election if you are wanting to run on a fiscal year other than the required tax year. For item R, your fiscal year must end in September, November, or December OR your business does not meet Provisions in Q. You will need to file accompanying form 8716
Terminating an S election with the IRS
There is a process for terminating an S election. There should be a scheduled vote for termination recorded in a meeting, with consent amongst 50% of the shareholders. Then, a managing member must send a Revocation of S Corporation Election letter to the IRS. The letter should include signatures from the consenting members, their Social Security Numbers, percentage of shares owned, and the termination date for the S Corporation.
Once s election is revoked, you can’t go back for 5 years. If you are revoking to become a C Corporation, there are strict rules in place for how to treat income. In some rare instances there might be tax consequences. Always consult with your accountant before restructuring.
S Corp Election for LLC and Corporations
With an s election you are afforded the luxury of a corporation, without the taxes. You can bypass half of self-employment tax on your income, because your company is paying as your employer. While qualifying for specific S corporation deductions, your company can retain more income to reinvest and prosper. If you need any help with your restructuring, don’t hesitate to reach out to our expert tax consultant. S election is our specialty.