Dodging Double Taxation: Is an S-Corp Election Right for Your LLC?
Are you a prospective business owner in Colorado looking to limit your tax liability? The type of entity you form has enormous tax implications, so you must be familiar with your options to choose the right one for you.
What is an S-Corporation?
An S-Corporation (S corp.) is a corporation that is taxed like a sole proprietorship (if there is one shareholder) or a partnership (if there are two or more shareholders). S corps pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. The corporation passes its profit to shareholders without paying any taxes. After the profit flows through the corporation, shareholders of S corps report the income and losses on their personal tax returns to be assessed at their individual income tax rates. This flow-through allows S corps to avoid double taxation on corporate income. However, S corps are responsible for tax on certain built-in gains and passive income at the entity level.
What is an S-Corporation Election?
If you have organized your business as a corporation, you have a choice as to how your business will be taxed by the Internal Revenue Service (IRS). It can be taxed as either a C corporation (or C corp.), or as an S corp. If you organize a corporation without making a tax election, it will be taxed as a C corp.
What are the benefits of an S-Corporation Election?
The primary benefit of an LLC taxed as an S corp. is saving money through the avoidance of double taxation. Double taxation is when profits are taxed once at the corporate level, then taxed a second time when profits are distributed to the shareholders. Unlike a C corp., an S corp. files a Form 1120S, U.S. Income Tax Return. No corporate tax is assessed on any profits reported on a Form 1120S. As mentioned above, profits are divided amongst the shareholders, who then report their share of the profits on their individual Form 1040, along with Schedule K-1 (Form 1120S), Shareholder's share of income, deductions, credits, etc. Therefore, through filing these forms for an S corp., you get the benefit of the corporate form for your business, but eliminate the double taxation inherent in C corps, where corporate income is taxed once and payroll is taxed again.
Another benefit of an S corp. election is the ability to take distributions monthly, quarterly, or annually. This allows for some flexibility in cash flows. Since many small businesses have issues with cash flows, an S corp. election can help provide a buffer.
Finally, S corp. elections can help you to enhance business operations. The amount of distribution is based upon how well the company is doing. This can help to encourage shareholders to ensure that the business is running at peak efficiency.
How does an S-Corporation affect my self-employment taxes?
With an S corp. election, you’ll also benefit by saving money on your self-employment taxes. Self-employment tax refers to Social Security and Medicare taxes, which total 15.3% of your net income (income minus expenses). The breakdown is 12.4% for Social Security tax and 2.9% for Medicare tax. These self-employment taxes are paid to the Social Security Administration and you’ll report these taxes as part of your personal federal tax return (Form 1040) on Schedule SE.
The way an S corp. saves money on self-employment taxes is by “splitting your income” into two groups:
· Salary (also called wage or payroll); and
· Distribution (also called dividend or profits)
Once your LLC is taxed as an S corp., you become an “employee-owner” (also referred to as a “shareholder-owner”). You own your company while also working for your company. With this “income splitting,” you are only required to pay the 15.3% self-employment tax on your salary. Your extra money left over (distributions) is not subject to self-employment tax.
An S corp. is unlike an LLC taxed as a Sole Proprietorship or Partnership. In these tax classifications, you pay self-employment tax on all of your net income and there is no option to split your income and save money on self-employment tax.
However, the IRS is aware of this slight loophole in S corp. tax elections. Therefore, they require you to take what’s called a “reasonable salary,” as determined by what reasonable compensation is for the services provided, before you can split income and avoid the self-employment tax.
Who can take an S-Corporation Election?
To qualify for S corp. status, the corporation must meet the following requirements:
Be a domestic corporation and file Form 2553.
Have only allowable shareholders.
May be individuals, certain trusts, and estates, and
May not be partnerships, corporations, or non-resident alien shareholders.
Have no more than 100 shareholders.
Have only one class of stock if you have issued stock.
Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).
Most firms can meet these requirements, but maintaining the status to minimize taxes also requires paying owners a fair salary. While an S corp. election allows your company to be treated as a pass-through entity, the IRS requires shareholders of S corps to receive a salary, which is subject to payroll taxes, if the shareholders perform services for the company. S corp. status can be revoked if shareholders do not pay their share of payroll taxes. To avoid status revocation, there are two viable ways for S corps to compensate shareholders: (1) pay yourself a reasonable salary, which is taxed at the same rate as an LLC, or (2) pay earnings on top of your reasonable salary as a distribution. The money distributed to shareholders under the second option is not subject to the 15.3% payroll tax, which lowers tax liability and saves money.
How do you make an S-Corporation Election?
In order to have the company taxed as an S corp., you need to notify the IRS that you are choosing, or “electing,” to have your company taxed as an S corp. To make the election, you need to file IRS Form 2553, Election by a Small Business Organization. If you file Form 2553, you do not need to file Form 8832, Entity Classification Election, as you would for a C corporation. You can also refer to the Instructions on Form 2553 for more directions and for the requirements to make the proper election.
How long do you have to make an S-Corporation Election?
An S corp. election can be made by filing Form 2553 no later than two months and 15 days after the beginning of the corporation's tax year. If you currently have a C corp. and wish to change to an S corp. for the next tax year, you can also file at any time during the current tax year.
Regardless of your business structure, the S corp. election can be a good option to lower your tax liability and save money. If you are a business that is unfamiliar with the election process, or you’re not sure if you have the infrastructure to handle the payroll requirements and the forms necessary to administer the change, then you may need to hire a professional’s help. GLO has a wide range of experience assisting business owners through the S corp. election process and can answer any questions you may have. Fill out an interest form today to see if GLO can help you.
GLO has prepared this blog to provide general information on legal issues that may be of interest. This blog does not provide legal advice for any specific situation and this does not create an attorney-client relationship between any reader and GLO or its attorneys. GLO engages clients only through specific fee arrangements and signed engagement letters. GLO does not guarantee any results.