What Is an S Corporation?

An S Corporation is a Corporation (including Professional Corporations) or Limited Liability Company (LLC) that elects to have special tax treatment under Sub-Chapter S of the Internal Revenue Code. S Corporations are taxed on a pass-through basis, with income, losses, credits, and deductions “passed through” to their shareholders’ personal income tax returns. The underlying business entity (e.g., LLC or Corporation) retains its liability protections and compliance obligations.

The S Corporation election can be ideal for small to mid-size businesses and business owners who want the liability protection of a formal business structure, the ability to reduce their self-employment tax obligations, and fairly uncomplicated income tax preparation requirements.

Advantages and Disadvantages of an S Corporation

The S Corporation election offers a number of potential benefits to consider:

• Avoids the double taxation of a C Corporation
• Helps business owners lower their self-employment tax burden because only income paid to the business owners through payroll is subject to Social Security and Medicare taxes (a.k.a. FICA) Profit distributions are subject to income tax but not FICA
• Provides personal liability protection for business owners, officers, and directors
• Simplifies income tax reporting (in the case of C Corporations electing to be taxed as S Corporations)

As with any business entity decision, there are also some possible drawbacks to be aware of before choosing the S Corporation election:

• May elevate IRS scrutiny since some shady characters have used the S Corporation election as a way to “game the system,” paying themselves a lower than reasonable wage or salary to inappropriately reduce Social Security and Medicare taxes or other payroll taxes
• Limits the number of shareholders and who may be a shareholder of the entity
• Requires careful attention to ensure the S Corporation pays its shareholders reasonable compensation based on the industry, geographic location, work performed, and other factors
• Has more complex tax reporting requirements for LLCs when taxed as S Corporations rather than when they keep the default treatment (i.e., Single-Member LLCs are by default taxed as a Sole Proprietorship and Multi-Member LLCs are normally taxed as a Partnership)
• May require a special state filing for recognition of S Corporation tax treatment at the state level—not all states recognize the election for state income tax purposes

Requirements for Electing S Corporation Tax Treatment

For an entity to be eligible for S Corporation status, it must meet the following criteria:

• Be a domestic corporation (or other entity eligible to be treated as a Corporation)
• Have only allowable shareholders (individuals, certain trusts, and estates), Partnerships, Corporations and non-resident alien shareholders are not permitted
• Have no more than 100 shareholders
• Have only one class of stock
• Cannot be an ineligible corporation, such as certain financial institutions, insurance companies, and current or former domestic international sales corporations (DISCs)
• Have a tax year ending on December 31 or meet the qualifications (or obtain approvals) for using a different fiscal year

To be taxed as a S Corporation, an entity must submit IRS Form 2553, signed and dated by a corporate officer. All shareholders must also consent to the election by signing the form and providing information about their shares in the company, tax ID number, and month and day of the end of their tax year.

State Considerations

Most states automatically recognize the federal S Corporation election and apply it for state income or franchise tax purposes. However, a few exceptions exist, with some states granting special tax treatment when S Corporations file a state form to request it while other jurisdictions do not provide S Corporation tax treatment under any circumstances.

States requiring a state-level S Corporation filing or additional fling:

• New Jersey (entities authorized to conduct business prior to December 22, 2022) – Online SCORP application required to make an affirmative election to be treated as an S Corporation for NJ purposes. Entities authorized to conduct business on or after December 22, 2022, must show proof of their federal S Corporation status and submit a Shareholder Jurisdictional Consent form.
• New York (except for New York City) – Form CT-6 required to allow individual shareholders to report corporate income on their ow,n state tax returns
• Louisiana – Accepts federal S Corporation election but taxes entities the same as regular corporations. In other words, an S Corporation will be subject to franchise tax. In addition, all shareholders who are Louisiana residents are required to exclude their portion of income and expenses on the corporate tax return and include them on their Louisiana individual income tax returns. Lastly, nonresident shareholders can elect to file individual nonresident and part-year resident Louisiana tax returns for their portion of the income and expenses or have the corporation pay the taxes at the corporate income tax rate for their portion of the income.
• Georgia – Accepts federal S Corporation election, but Form 600S-CA is required to confirm nonresident shareholders’ agreement to pay Georgia income tax on their proportionate part of the corporation’s taxable income.
• Mississippi – Form 84‑380 required to confirm nonresident shareholders’ agreement to pay Mississippi taxes on their proportionate part of the corporation’s taxable income.

Jurisdictions that do not offer pass-through tax treatment to S Corporations:

• New York City
• District of Columbia
• New Hampshire
• Tennessee
• Texas

How to Apply for S Corporation Status

The steps for electing S Corporation tax treatment may vary slightly depending on whether the entity is brand new or existing and where it’s located. Here are the general requirements:

1. 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.
2. Business owners must also follow through with other requirements for starting an LLC or C Corporation legally.
3. An LLC must file IRS Form 2553 (Election by a Small Business Corporation) to request Subchapter S Corporation tax treatment.
4. A C Corporation must file IRS Form 2553 to request that it’s taxed as an S Corporation.
5. For S Corporation tax treatment by the state (if available), businesses must complete any required state forms.

Deadlines for Filing for the S Corporation Election

Entities that want the election effective at the start of the next fiscal year may file Form 2553 anytime in their current fiscal year.

However, timing matters when applying for S Corporation status for the current tax year! Existing LLCs and C Corporations with calendar tax year (i.e. January 1 – December 31) have two months and 15 days (75 days) to file IRS Form 2553 to request S Corporation status for the tax year. Generally, that falls around March 17 and can vary depending on whether the 75th day falls on a weekend or if we’re in a leap year). Businesses that follow a different fiscal year have until two months and 15 days after the start of their fiscal year to complete their S Corporation election form.

New LLCs or C Corporations have two months and 15 days from their date of formation or incorporation to file for S Corporation tax treatment.

Filing after the deadline means the election will be effective the following tax year unless granted relief for a late election.

To obtain relief, the company must have “reasonable cause” for filing late. Examples of reasons the IRS might deem valid include:

• The business’s responsible party, accountant, or tax professional failed to submit Form 2553
• The corporation’s leadership or shareholders weren’t aware they had to submit Form 2553 to the IRS
• The corporation’s leadership or shareholders weren’t aware of the deadline for submitting Form 2553

When requesting relief due to reasonable cause, the client should prepare to explain the facts of why they missed the deadline and are filing late. Also, they should disclose how they handled tax affairs when they wanted to be considered an S Corporation but weren’t yet approved to do so. Another critical point to communicate is what the LLC or C Corporation did to fix the situation upon learning they hadn’t requested the S Corporation election correctly.

Receiving Approval Confirmation of Your S Corporation Election

Businesses should receive mail confirmations from the IRS regarding the status of their request and whether it was approved (specifically, a CP261 Notice is received to confirm approval). Generally, the expected response time is two to three months after Form 2553 was filed. Unfortunately, some business owners wait for a year or longer to receive a response — and some never receive a confirmation from the IRS.

If you don’t hear from the IRS within two to three months, we recommend you follow up with the IRS to determine if the agency approved the application. Usually, calling the IRS to speak with an agent yields the fastest response. The IRS contact number is 800-829-0115. After selecting the language of choice, you should choose #3 for “all other business notices and letters.”

Business owners should be prepared to verify their identity and have other important information at their fingertips (e.g., a copy of their completed Form 2553, information about the business’s responsible party, Social Security Number, and business EIN) during the call to answer any questions the agent might ask.

Depending on when you call, they might experience an “on-hold” time of anywhere from 30 minutes to two hours before speaking with a live person. This may be especially true during the height of tax season, so business owners will need a little extra patience and persistence if calling them.

FAQs About S Corporations

What ongoing compliance does an S Corporation require?

An S Corporation must follow the same compliance formalities of its underlying business entity (e.g., Single Member LLC, Multi-Member LLC, or C Corporation). For instance, a Limited Liability Company that’s an S Corporation for federal tax purposes must abide by the provisions of its LLC operating agreement and fulfill any state-mandated reporting, licensing, and tax responsibilities that apply to LLCs. Similarly, a Corporation with the S Corporation election must continue to follow its corporate bylaws and fulfill any state-mandated reporting, licensing, and tax responsibilities that apply to Corporations.

Can an S Corporation own an LLC?

Yes. An S Corporation may own a Limited Liability Company. This is true for both Single-Member LLCs and Multi-Member LLCs. In theory, an S Corporation could own as many LLCs as its shareholders agree upon because there are no limits on the number of members an LLC may have.

However, an LLC may not own an S Corporation per the IRS’s shareholder eligibility rules.

What are the reasonable salary rules for an S Corporation?

According to the IRS, reasonable compensation is “the value that would ordinarily be paid for like services by like enterprises under like circumstances.”

While the IRS doesn’t require a specific formula for determining shareholders’ reasonable wages or salaries (it is determined on all the facts and circumstances), the agency does suggest considering the following factors:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Distributions history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Where the company is located
• Compensation agreements
• The use of a formula to determine compensation

To get an idea of what similar companies are paying employees, consider available information through the U.S. Bureau of Labor Statistics, Glassdoor, Indeed, Payscale, and ZipRecruiter.

Where is the best state to incorporate an S Corporation?

An S Corporation is not an entity in and of itself; it’s a special tax election that eligible LLCs and Corporations may request. So, a better question is “Where is the best state to form an LLC or a Corporation?” The answer depends on many factors. In most cases, the state where a company has its principal place of business and conducts most of its activities will be most advantageous. That said, a business entity can be domiciled (i.e., registered as a domestic entity) in any state even if they don’t have operations there. However, if business owners form their domestic entity in a particular state merely because they’re drawn to its business-friendly legal system or tax code  (Delaware, Texas, and Nevada are popular choices for those reasons), they also will likely have to file for foreign qualification in the state(s) where they live and actively conduct business. In addition, they will need to fulfill all ongoing compliance requirements in both states.

Do you need a new EIN when converting an LLC to an S Corporation?

No. When an LLC files for the S Corporation election, it retains its existing Employer Identification Number. The entity itself remains the same as before, it’s simply choosing to be treated differently for income tax purposes.

Does an S Corporation protect personal assets?

Yes. The personal liability protections of the entity (e.g., LLC or Corporation) that elects S Corporation tax treatment remain intact. Under most circumstances, the shareholders, directors, and officers of an S Corporation will not be held personally responsible for the debts and legal obligations of the business.

Does the S Corporation election expire?

No. The election remains in effect indefinitely unless the business owners voluntarily revoke it or it is terminated by the IRS for ineligibility or lack of compliance.