The S Corp tax is a tax status, not a business entity. If you are a sole proprietor, S Corp taxation is not an option. Instead, you must establish a separate business entity in your state. You can then choose S Corp tax status by submitting an election to the IRS (Internal Revenue Service). To understand how S Corps can save you money, we need to start with the basics. When you are a sole proprietor, you will report all of your business income on Schedule C, Business Profit and Loss, and file it with your federal and state personal tax returns. Now, let’s say you make a $100,000 profit as a sole proprietor in California. You will pay three separate taxes on this profit:
- Federal income tax
- California Income Tax
- Social Security and Medicare Taxes
As a sole proprietor, you must pay all Social Security and Medicare taxes yourself. No employer can pay you half of these taxes. And these taxes are high!
When to choose the S election
Since S corps owners must pay their own salary and receive tax benefits only from dividends, many businesses choose to wait to opt for S corp status until the income generated by the corporation makes the tax designation worthwhile. As a general benchmark, many entrepreneurs will wait until their company starts liquidating $50,000 in annual profits. $50,000 is where it starts to make financial sense due to expenses incurred for payroll services and general W2 payroll. For example, if you took $50,000 and paid yourself $40,000 in salary, you would be left with $10,000 to pay as dividends. At that point, the tax savings from the $10,000 dividend ($1,530) may cover payroll expenses.
S Corporation Requirements
While S Corp Late Election can offer entrepreneurs a wide range of advantages, they are not without limitations. The following are the requirements for LLCs and corporations seeking S corporation tax status:
LLCs and corporations applying for taxation as S corps must be domestic corporations
- Distributors or members of S corps must be individuals, buildings, or other types of trusts; S corp partners may not be affiliates, other companies, or non-US citizens.
- S Corps may have only one class of records
- S corp must not have more than 100 shareholders (or members or LLCs)
- Some types of companies are not eligible: other financial institutions, insurance companies, and domestic and foreign retail companies
- All shareholders or members are required to pay their dues at a reasonable rate
- Shareholders or members directly bear the profit and loss according to their share
Submit Form 2553
As mentioned above, to apply for S corporation tax status, you will need to file a Form 2553 S Corp Election with the IRS. The form is fairly simple. Before you start, however, there are some key details you should know about the form itself:
- You must apply for S corp tax designation within two months and 15 days after the first day of the tax year
- On the form, you must include each shareholder or member’s name, address, social security number (or EIN, if applicable) and tax year end date
- You must also list the number of shares or percentage ownership of each shareholder or member and the date the shares or percentage were acquired
- All shareholders or members must consent to the S corp election by signing and dated on column K of the form
- For detailed instructions on filing an S election, see the Instructions for Form 2553.
While the S-election has a reputation for being the best tax designation, it’s not always the best choice for every business — especially if your business doesn’t have enough money to meet the mandatory wage requirement of “reasonable compensation.” Additionally, many businesses simply cannot qualify for an S election due to restrictions on stock class, shareholder, nationality, and field of business. In fact, there are many misconceptions about S corporations to consider before choosing the IRS. It’s also important to remember that an S election is a federal tax designation that affects your federal taxes. State taxes can be very different, so it’s a good idea to research how your state treats S corporations.
Most states recognize S elections and will tax your business in much the same way that they are taxed at the federal level. However, some states do not recognize S elections for state taxes, while others have the potential to apply franchise or excise taxes on S corporations. That said the S election has benefited some corporations and LLCs significantly, saving a lot of taxes.