S Corporation qualification requirements:
- The entity must be an eligible domestic corporation (or LLC) – ineligible corporations include certain financial institutions, insurance companies, and domestic international sales corporations.
- The entity may have no more than 100 shareholders.
- The entity must have only individuals, certain trusts, or estates as shareholders (no shareholders may be partnerships, corporations, or non-resident alien shareholders).
- The entity may have only one class of stock.
Why might it be beneficial for a Partnership to be taxed as an S Corporation? Let’s first look at how being taxed as an S Corporation is different from being taxed as a Partnership.
How a Partnership Is Taxed
By default, a Partnership is a pass-through entity—i.e., it is the same tax-paying entity as its owners (partners). Therefore, all of the business’s profits, losses, credits, and deductions flow through to the partners who must report their share of the Partnership’s income on their individual tax returns. While the business must file Form 1065, an information return, to the IRS and Schedule K-1 to its partners, it does not pay income tax at the corporate level.
In addition to income tax, the partners are also responsible for self-employment taxes (Social Security and Medicare). Partners may not be on company payroll and do not receive paychecks from their company, so no Social Security or Medicare taxes are withheld or paid by the business.
Typically, partners must report and pay their income taxes and self-employment taxes quarterly; and they report them on their annual tax returns and must pay any remaining taxes owed if their quarterly payments fall short. If they overpaid, they receive a tax refund or credit.
How an S Corporation Is Taxed
An S Corporation is also a pass-through entity*, but shareholders that work for the company are on payroll. Therefore, the company withholds income tax, Social Security and Medicare taxes (FICA), and makes other mandatory and voluntary deductions from those shareholders’ pay. Unlike with the default Partnership tax treatment, only the partners’ wages and salaries are subject to Social Security and Medicare taxes; any profit distributions they receive from the business are subject to income tax but not FICA. Moreover, an employee-shareholder only has to pay half of their Social Security and Medicare burden, which the business withholds from the individual’s pay, and the S Corporation is responsible for paying the other half.
After its tax year concludes, the S Corporation files Form 1120-S, an information return with the IRS, and sends each of its shareholders a Schedule K-1 (as a record of their share of the company’s profit or losses) and each of its employees (including any shareholders on payroll) W-2s.
Like a Partnership, S Corporation shareholders must report and pay quarterly estimated taxes on income that is not withheld from their pay (i.e., profit distributions).
*Note that an S Corporation may also have to make estimated tax payments if the total of its taxes on built-in gains, excess net passive income tax, and investment credit recapture tax reach or exceed $500.
Potential advantages of being taxed as an S Corporation:
- May lessen a business owner’s personal tax burden while retaining the convenience of pass-through taxation
- Avoids the complexity and double taxation of filing taxes as a C Corporation
- Does not require an LLC to take on the more stringent compliance requirements of a C Corporation
- Retains the limited liability protection of the LLC business structure
How to Become an S Corporation
Technically, there is no such thing as “converting” to an S Corporation because it is a tax election choice, not a different entity type. So, for a Partnership to get the benefits of S Corporation election, its partners must first convert the business to a Multi-Member LLC. That process can vary depending on the state’s laws and the type of Partnership.
Form 2553 to request S Corporation election may be submitted to the IRS as soon as an LLC is formed. Newly formed LLCs have two months and 15 days (75 days) after their formation to file the form for the S Corporation election to be effective for the LLC’s entire first tax year. So, a new LLC formed on May 1 would have until June 15 from that date to file.
If electing S Corporation tax treatment for an existing LLC, timing matters if the owners want the election to be effective for the current tax year. The IRS requires the election to be filed within two months and 15 days (a total of 75 days) after the start of the tax year. For businesses that use the calendar year, that date is right around March 17 (the exact date can vary if the 75th day falls on a weekend or we’re in a leap year). If a Multi-Member LLC files Form 2553 after the March deadline, it will be taxed as a Partnership for that entire current tax year and the S Corporation election (if approved) will be effective for the following tax year.
LLCs that want S Corporation effective for the following tax year can file their Form 2553 at any time during the current tax year.
More Helpful Resources
I think you’ll find the articles below helpful as you consider going from a Partnership to an S Corporation. I encourage business owners to consult a licensed accounting or tax professional to better understand the effects of changing how a company is taxed.
CorpNet Is Here to Help
Save time, money, and avoid confusion when creating or changing your business entity. CorpNet can help prepare and file your paperwork for you!
