A business may elect to be an S Corporation (S Corp) by filing form 2553. This will provide additional tax benefits for the S Corporation as there is no taxation at the corporate level. All profits and losses will pass through at the shareholder level.
Restrictions on S Corporation
The following are the requirements to make an S Corporation election :
The S corporation needs to be a domestic corporation. They must have been created under federal, state, or U.S. territory
S Corporation election should be approved by all shareholders
One class of stock can be issued by the corporation. This stock can have both voting and nonvoting shares.
S Corporation can have a maximum of 100 shareholders. Husband and wife are counted as one member.
Nonresident aliens or non-human entities are not allowed to be shareholders. Estate or trust that is authorized to be an S corporation shareholder under the tax laws is permitted as a shareholder. Certain exempt organizations, such as qualified pension, profit-sharing, and stock bonus plans, or charitable organizations will be allowed to be shareholders in an S corporation (for purposes of determining the number of shareholders of an S corporation, a qualified tax-exempt shareholder counts as one shareholder).
An S Corporation can own 80% or more of C Corporation. Also, it can hold certain qualified wholly owned subsidiaries and C Corporation subsidiaries. The C corporation subsidiary can then elect to join in the filing of a consolidated return with its affiliated C corporations, but the S corporation cannot join in the election.
Risks associated with S Corporation.
IRS takes a closer look at S Corporation to ensure salaries are consistent with industry standards. AS an example, if you generated $200,000 of net income, but only designate $10,000 as salary, then there is a higher chance of IRS intervention as you are trying to avoid self-employment taxes.
S Corporation costs
Certain states like California require you to pay 1.5% of income with a minimum annual franchise tax payment of $800. This is not required for sole proprietors.
In addition, there are costs associated with the board of directors, by laws and maintaining all compliance documents to maintain S Corporation status.
Advantages of an S Corporation:
No double taxation. There is no taxation at corporate and shareholder level. All taxes are filed at the shareholder level.
Shareholders are not personally liable for the debts of the corporation.
Disadvantages of an S Corporation:
An S corporation may have some potential disadvantages, including:
Formation and setup expenses. The expenses in the formation and ongoing compliances may be relatively higher compared to sole proprietors.
Compliance issues: If not managed well, there can be additional penalties or interest for incorrectly assessing S Corporation salaries or not filing the reports timely.
Stock ownership restrictions. An S corporation can issue only one class of stock. This can have both voting and nonvoting rights. Therefore, there can’t be different classes of investors who are entitled to different dividends or distribution rights. Also, there cannot be more than 100 shareholders. Foreign ownership is not permitted, and there are few conditions on ownership by certain types of trusts and other entities.
Closer IRS scrutiny. There is increased scrutiny. Therefore careful consideration should be made at the time of determining the S Corporation owner salaries.
How are S Corporations taxed?
All S Corporations will need to file form 1120 S.
S Corporations are pass through entities. You need to incorporate in a particular state. You need to then file form 2553 to be elected as an S Corporation.
With S Corporation election, there is no double taxation. The income and losses of S Corporation are pass through to the shareholders similar to partnership pass through to the partners.
Tax benefits of S Corporation
Below is an example of how S Corporation can help save taxes.
As an S Corporation, you are required to take a Salary as you will be considered an owner-employee. Eg: You earn $100,000 a year, you will need to determine a reasonable salary based on your tax situation eg:50,000. Please, however, note that there has been a lot of discussion around S corporation salary. Therefore, consult a qualified Certified public accountant who specializes in S Corporations.
In short, you will be paying:
Payroll taxes as an employee. As an employer, you will be filing all the required 940, 941s, W2s,1099s.
As an S Corporation, you do not have to pay medicare and social security taxes on your distributions. EG: If you have $100,000 annual income and you take $50,000 as salary. You pay $7,650 ($15.3% as taxes).
If you do not choose S Corporation taxes, you will incur additional Medicare ($1,450) and social security taxes ($626)
Because of this tax advantage, many LLCs now elect to be taxed as an S Corporation. Please note that you need to take salary otherwise there will be IRS scrutiny which in turn may lead to penalties and interest.
As an S Corporation, you will file form 1120 S and distribute K1 to the owner-employee
When can you make the S Corporation election?
If you must make a tax election for the current year, you have a small window. You are required to file form 2553 within 2 months and 15 days of the tax year that you would like the election to take effect.
There are special rules relating to the late election which is complex and best if handled by a tax professional.
How are profits and losses allocated to S Corporation?
In S Corporation, all profits and losses and another pass through items are allocated according to shareholders allocated a share of stock. As an example: if you own 40 percent of the stock, you must receive 40 percent of the losses, profits, credits
This is significantly different from a partnership. In a partnership, the partnership agreement can state various different partnership profit or loss percentage for different tax items.
A partner can be allocated 30% of the profits in the first five years and 50% of the profits in the sixth year.
Payroll taxes and compliance
Owner employee will need to draw a salary as an S Corporation. The salary should be carefully determined based on several key factors. Usually, it is recommended at the time of S Corporation setup that you evaluate the industry standards & setup salaries accordingly.