Before the advent of the S Corporation in 1958, entrepreneurs had two options for forming a business entity. They could form a partnership or form a C Corporation. But neither of those business structures fulfilled the needs of many people seeking to start their own businesses. To help encourage small businesses in America, Congress and President Eisenhower created the Subchapter S Corporation.
You may be thinking, “That’s really interesting, Nellie, but unless I’m attending a business trivia night anytime soon, why should I care?”
Hang in there—we’re getting to that! Whether you’re a business owner or a professional service provider that gives entrepreneurs legal or tax advice, you’ll want to understand what a Subchapter S Corporation is and whom it can benefit.
What is a Subchapter S Corporation?
Named after the section in which it appears within the Federal Internal Revenue Code, the Subchapter S Corporation is an IRS tax election option available to eligible businesses. You have probably heard it called “S Corporation” or “S Corp,” as well.
In a nutshell, electing to be considered an S Corporation allows businesses formed as Limited Liability Companies or C Corporations to receive special tax treatment.
Choosing the S Corporation election has some significant advantages for some businesses. On the flip side, it’s not ideal for every business. So, it’s critical that entrepreneurs get expert tax and legal guidance before deciding to become a Subchapter S Corporation.
In this post, I’m going to run through some of the S Corporation pros and cons to consider.
- May decrease the self-employment tax burden on members of an LLC – Normally, an LLC is considered a pass-through tax entity. All of an LLC’s profits pass through to its owners’ (a.k.a. “members”) personal tax returns. LLC members pay income tax and self-employment taxes (Social Security and Medicare) on all of the business’s profits. As a Subchapter S Corporation, however, only wages and salaries paid to LLC members through payroll are subject to self-employment taxes. The remaining profits paid as distributions to LLC members don’t get hit with Social Security and Medicare taxes.
- Helps C Corporations avoid the sting of double taxation – A C Corp pays income tax on its profits at the corporate tax rate. Then, profits that the C Corporation distributes as dividends (which are not tax-deductible for the C Corp) get taxed again on the shareholders’ individual tax returns. However, with the Subchapter S Corporation election, the corporation’s profits and losses flow through to its shareholders’ personal tax returns immediately and are not taxed at the corporate rate. Shareholders that are employees of the corporation pay self-employment taxes only on the wages or salaries they receive from the business. They do not pay Social Security and Medicare taxes on income paid to them as dividends.
- Provides personal liability protection for business owners – Creditors usually may not pursue the personal assets (house, bank accounts, etc.) of an S Corporation’s owners to pay business debts to settle legal disputes.
- Allows LLCs to retain their ease of administration – LLC members can breathe a sigh of relief knowing that by choosing to be a Subchapter S Corporation, they retain much of their administrative simplicity. There may be additional tax reporting requirements, but usually, the underlying formalities to maintain an LLC remain the same.
- Transfer of ownership – A corporation taxed as a Subchapter S Corporation can transfer ownership through transferring stock. Changing ownership interests isn’t quite as straightforward with other types of business entities.
- Cash accounting method – C Corporations (with gross receipts of over $5,000,000) must use the accrual method of accounting. S Corporations, unless they have inventory, may do their accounting on a cash basis, which is less complicated.
- A credibility boost – A business might find that potential customers, vendors, and partners perceive it as more credible if it operates as an S Corporation rather than a sole proprietorship or partnership. That boost of confidence might result in more opportunities for the business.
- May stunt a business’s growth – Subchapter S Corporations may not have more than 100 shareholders. In contrast, LLCs can have unlimited members, and C Corporations can have an unlimited number of shareholders.
- May come under closer scrutiny by the IRS and other tax authorities – Businesses that elect S Corp status must be cautious when setting up members on the payroll. Wages and salaries to owners must be reasonable for the type of work and industry. If an S Corp pays its owners low wages so that it can hand out the majority of the profits as distributions (to avoid self-employment taxes), it may alert the IRS that something’s amiss. In response, the IRS may recharacterize wages and distributions—which will affect tax outcomes.
- No uniform S Corporation tax treatment across states – While some states honor the federal S Corp election automatically, others disregard S Corporation status entirely. And then some states require additional filings to complete S Corp election at the state level.
- More strict ownership requirements – Only eligible domestic corporations and LLCs qualify for S Corp status. Also, the IRS restricts who may be shareholders of an S Corp. Partnerships, corporations, and non-resident aliens are ineligible. In contrast, LLCs and C Corporations have fewer restrictions on who may own them. The IRS website explains more about the S Corp eligibility requirements.
- Possibly higher shareholder tax burden – Because of the flow-through taxation (business income taxed at the individual tax rates) with the S Corporation, shareholders of a corporation may end up in higher tax brackets. So, potentially, they could end up paying more in taxes than if the business went with C Corporation default tax treatment.
- Must use the calendar year as the tax year – Unless the IRS approves a business’s request to have a different arrangement, Subchapter S Corporations must adopt a calendar year as its tax year. IRS Form 8716 (Election to Have a Tax Year Other Than a Required Tax Year) must be submitted to request a tax year other than the calendar year.
- Only one class of stock allowed – Unlike C Corporations, an S corporation may only have one class of stock. That means the corporation cannot have different classes of investors that get different distribution rights.
- Payroll responsibilities – Owners who do substantial work for a Subchapter S Corporation are considered employees. That brings payroll responsibilities, which involve making sure owners get paychecks with the correct withholdings of income taxes, Social Security and Medicare taxes (FICA), unemployment taxes (FUTA), and possibly other taxes.
How to Form a Subchapter S Corporation
Business owners must first either form an LLC or a C Corporation. That involves filing Articles of Organization (LLC) or Articles of Incorporation (C Corporation) with the state. Business owners must also follow through with other requirements for starting an LLC or C Corporation legally.
The next steps for forming a Subchapter S Corporation include:
- An LLC must file IRS Form 8832 (Entity Classification Election) to identify it wants to be classified as a corporation for federal tax purposes. It must also file IRS Form 2553 (Election by a Small Business Corporation) to request Subchapter S Corporation tax treatment.
- A C Corporation must file IRS Form 2553 to request that it’s taxed as an S Corp.
- For S Corporation tax treatment by the state (if available), businesses must complete any required state forms.
Business owners should understand what they must do to conduct business legally as an S Corporation. After they have talked with their attorney and tax advisor, CorpNet is here to handle the preparation and filing of the state’s business registration and IRS forms to ensure all of the paperwork is done accurately and on time.
When is the Election Deadline?
The deadline for the Subchapter S Corporation election varies depending on a business’s situation. Here’s a rundown of the scenarios:
- Existing LLCs and corporations (with a tax year that began on January 1) will need to file IRS form 2553 no later than March 15, 2020 to receive S Corp tax treatment for all of the 2020 tax year.
- Businesses with a tax year that does not match the calendar year have until two months and 15 days after the start of their fiscal year to complete their S Corp election paperwork.
- Businesses that want their S Corporation election to be effective starting in 2021 can file at any time during 2020.
- New LLCs and C Corporations have two months and 15 days from their date of incorporation to file for S Corporation tax treatment for the rest of the year.
Visit the IRS website for more details about S Corp filing deadlines.
What Happens if You File Late?
Note that a delay in filing for S Corp election will likely result in a business needing to file two separate tax returns at the end of the year.
Generally, if a business files as an S Corporation after its deadline, it will be taxed as one entity type for part of the year and then as an S Corp for the remainder. As an example, let’s say a business called Lara’s IT Consulting, LLC was formed in 2019. Lara now wants to have her LLC taxed as an S Corp in 2020, but she missed the March 15 deadline. If she files her Form 8832 and Form 2553 on April 6, 2020, her company will be taxed as an LLC from January 1 through April 5 and then as an S Corporation from April 6 through December 31. This results in Lara having to prepare two sets of tax forms for the year.
Note that the IRS does provide some leeway for businesses that have a reasonable cause for not filing Form 2553 on time. The business owner must explain on Form 2553 why they filed the form late. Upon IRS approval, the S Corp status will be made retroactive to the start of the tax year.
Are You Ready to Start a Subchapter S Corporation?
If you’re a business owner considering the S Corporation election, seek the expertise of legal and tax professionals who can help you weigh all the pros and cons. By making an informed decision, you’ll have the peace of mind that the S Corp path is right for you. And, with CorpNet here to help, you’ll have the confidence that all of your business formation and S Corporation forms are done accurately and on time.
If you’re a legal or tax professional, use your expertise to help guide your clients as they decide if the Subchapter S Corporation election makes sense in their situation. Offer your expert guidance to give them the information they need to choose wisely. Also, consider signing up for the CorpNet Partner Program. You can choose to resell our business formation and compliance services or become a referral partner. Either way, you will provide your clients with additional value while adding a new revenue stream for your business.
Contact us to learn more!