“Make it an S corp” is among the most repeated pieces of founder advice, and one of the least explained. The IRS’s own description is more modest than the folklore: an S corporation is a way of being taxed, and it comes with conditions.
What an S corp is
The IRS says S corporations “pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.” Shareholders report those items on their personal returns at individual rates, which the IRS says avoids double taxation of corporate income. The company files its own return, Form 1120-S, and each shareholder gets a Schedule K-1.
The SBA’s structure guide puts the difference in context. A C corporation pays income tax on its profits, and dividends may be taxed again on personal returns. An S corporation’s profits, and some losses, pass through instead. The SBA also notes that S corps must still follow C-corp filing and operating rules, and that some states tax S corps differently or don’t recognize the election.
Who qualifies
Per the IRS, the company must be a domestic corporation with:
- only allowable shareholders (partnerships, corporations and non-resident alien shareholders can’t be shareholders);
- no more than 100 shareholders;
- one class of stock.
Certain financial institutions and insurance companies are ineligible.
The LLC route
You don’t have to start as a corporation. The Form 2553 instructions say an entity eligible to elect corporate treatment, such as an LLC, can elect S status by filing Form 2553. It is treated as a corporation from the effective date and doesn’t need to file Form 8832 separately. If a single-member LLC that is disregarded for tax purposes owns the stock, its owner must be eligible to be an S corporation shareholder. If you haven’t formed an entity yet, start with LLC versus sole proprietorship, because the election sits on top of that decision.
The deadline
The instructions say Form 2553 is due no more than 2 months and 15 days after the start of the tax year the election takes effect. You can also file at any time during the tax year before that. Missing it isn’t automatically fatal: a late election can be accepted if you show reasonable cause and acted diligently, within 3 years and 75 days of the effective date, with the notation “FILED PURSUANT TO REV. PROC. 2013-30” at the top of the first page and shareholder statements attached.
Two procedural traps from the instructions:
- Signatures. An authorized officer must sign and date the form, and an unsigned form isn’t considered timely filed. The IRS page on S corporations says the filing carries the signatures of all shareholders.
- Where to file. The address depends on where your principal business is located (Kansas City, MO or Ogden, UT). The IRS warns addresses may change, so check its Where to File page before mailing.
The catch: you have to pay yourself
The reason founders look at an S corp is that distributions aren’t subject to employment taxes. The IRS is explicit that this has a limit. Distributions “must be treated as wages to the extent the amounts are reasonable compensation for services rendered,” and the IRS “has the authority to reclassify payments made to shareholders from non-wage distributions.”
The IRS’s test starts with where the receipts come from. If gross receipts come from the shareholder’s own personal services, payments to her “should be classified as wages that are subject to employment taxes.” Payments tied to non-shareholder employees, capital or equipment can be treated as distributions. Factors the IRS lists include training and experience, duties, time devoted to the business, and what comparable businesses pay for similar services.
In practice, this is a payroll decision as much as a tax one. For the mechanics of salary versus draw, see how to pay yourself as a business owner.
Is it right for you?
This article can’t answer that, and neither can a rule of thumb. The IRS and SBA pages describe the rules, not whether the savings beat the added payroll, filing and state-tax costs for your income. A CPA who knows your state can run the numbers before you file.
Frequently asked questions
Is an S corp a type of company?
It is a federal tax status. The IRS says an entity eligible to elect corporate treatment, such as an LLC, can elect S corporation status by filing Form 2553, and is treated as a corporation from the election’s effective date.
When do I have to file Form 2553?
The IRS instructions say the form is due no more than 2 months and 15 days after the start of the tax year the election takes effect, or at any time during the tax year before that. Late-election relief exists for reasonable cause, within 3 years and 75 days of the effective date.
Can I skip paying myself a salary and take only distributions?
No, not if you do the work. The IRS says distributions must be treated as wages to the extent they are reasonable compensation for services rendered, and that it can reclassify non-wage distributions to shareholders as wages.
Who can’t be an S corp shareholder?
The IRS says an S corporation needs only allowable shareholders, no more than 100 of them, and one class of stock. Partnerships, corporations and non-resident alien shareholders can’t be shareholders.
Sources: IRS, “S corporations,” “S corporation compensation and medical insurance issues” and Instructions for Form 2553; SBA, “Choose a business structure.” This is general information, not tax advice. Rules and state treatment vary, so confirm with a tax professional.