If your business is a corporation, you’re already aware that March 15th is the most critical tax deadline of the year. But March 15th is an important deadline for another reason…it’s the deadline for electing S Corporation status.
Choosing the right business structure is a significant issue, one you’ll want to consider carefully from all angles. The S Corporation is a popular way for small businesses to optimize their tax treatment and with the S Corp election deadline approaching, it’s a good time to examine this business entity.
If you’re launching a new business or are considering switching your corporate status, read on to learn if the S Corporation is right for you.
What is the S Corporation?
Let’s start at the beginning. An S Corporation begins as a general, for-profit C Corporation. After the corporation has been formed, it can elect ‘S Corporation Status’ by filing Form 2553 with the IRS in a timely manner (we’ll cover deadlines in more detail below). With this election, the company is now taxed as a sole proprietor or partnership rather than as a separate entity like the C Corp. This means that corporate profits and losses are “passed through” and reported on the personal income tax returns of the shareholders. That’s why the S Corp is known as a ‘pass-through entity.’
What are the Benefits of the S Corporation?
The main reason to elect S Corporation status is to avoid double taxation. A C Corporation is a separate taxpayer that files its own federal and possibly state tax returns. Any profits are first taxed in the Corporation’s tax return. Then if the Corporation decides to take that profit and distribute dividends to shareholders, the dividends are taxed again (this time, on each shareholder’s personal tax statement).
As an S Corporation, the company pays no income tax. The profit is distributed to the shareholders as a dividend and each shareholder is taxed at the 15% qualifying dividend rate on their own personal tax return. Of course, bear in mind if a shareholder also works in the business, they must be paid a reasonable wage for their activities. And these wages are subject to the personal income tax rate (in other words, you can’t just compensate yourself in dividends).
The S Corporation entails extra structure, formalities, and compliance obligations for the solo entrepreneur with a “payroll of one.” If you incorporate as an S Corporation, you need to set up a board of directors, file annual reports and other business filings, hold shareholder’s meetings, keep records of your meeting minutes, and generally operate at a higher level of regulatory compliance than your business might need or want to deal with. Instead of dealing with all this red tape and complexity, forming an LLC might give you greater simplicity and ease of doing business. And, the LLC still gives you the pass-through tax treatment just like the S Corp.
The other downside of the S Corp is its strict allocation of income. In an S Corporation, each owner/shareholder must share in the income in direct proportion to their ownership. If you and a partner each own 50% of the business, you each will be taxed on 50% of the profits, regardless of any other agreements you might make about splitting up the profits. In contrast, an LLC offers more flexibility when it comes to allocating income amongst the owners.
Who cannot form an S Corporation?
The IRS places certain restrictions on S-Corps, including:
- An S-Corp cannot have more than 100 shareholders.
- All shareholders in an S-Corp must be individuals (not LLCs or partnerships) and legal residents of the United States.
- An S-Corp can have only one class of stock, so all owners must share equally in terms of profits and losses based on their percentage of ownership.
When is the S Corporation Deadline?
If you have an existing Corporation (C Corp) or LLC, March 15th is your deadline for filing IRS Form 2553 with the IRS and electing S Corporation status for this tax year and forward. In other words, if your corporation/LLC existed on Jan 1, 2012, you need to file form 2553 by March 15, 2013 in order to have your S Corp in effect for the 2013 tax year. However, if you form a corporation or LLC on June 1, 2013, then your S Corporation deadline is August 15 (75 days from June 1).
If you miss the deadline, you’ll most likely be taxed as a C Corporation for the current tax year, and then your S Corp election will be effective for the following tax year. The IRS may give you a pass if you can show that your failure to file on time was due to ‘reasonable cause.’ Of course, no one wants to be at the mercy of the IRS, so play it safe and get your form in on time.
Your choice in business structure will ultimately depend on all the unique aspects of your business. But regardless of which business type you choose, taking a serious look at your legal structure is essential to set your business up for success.