S Corp Status: What it is, How to File, and How it Can Benefit Your Business
Whether you just started your business or have been operating for some time as an LLC or a sole proprietorship, it may be beneficial to consider switching to an S Corporation (or “S Corp”). In this article, we’ll cover the basics of S Corp status — what it involves, its benefits, and what the filing process entails. If you previously thought your business wouldn’t qualify or that it would be too difficult to move your business to an S Corp, you may be in for a pleasant surprise.
What is an S Corp?
An S Corp gets its name from Chapter 1, Subchapter S of the Internal Revenue Code. It is a type of corporation that meets the specific requirements listed in that subchapter.
Notably, S Corps are known as “pass-through” entities: they can pass income, credits, deductions, and losses along to shareholders without having to pay taxes at the corporate level (although they are still liable at the corporate level for taxes on specific built-in gains and passive income). Shareholders report income and losses on their individual tax returns and pay taxes at individual rates (rather than corporate rates).
S corp status essentially gives a business the benefits of incorporation with the tax-exempt privileges of a partnership.
An S Corp issues shares of company stock and is governed as a corporation, with directors, officers, and shareholders who function in the same manner as in a corporation. But unlike a regular corporation, there is no “double taxation,” meaning that the owners/shareholders don’t need to pay taxes twice — once at the corporate level and again at the shareholder level.
Aside from their tax status, S Corps are similar to any other corporation — they are for-profit companies incorporated under and governed by the same state corporation laws. They have similar liability protection, ownership, and management advantages as a corporation.
They must also follow similar internal practices and formalities, such as having a board of directors and corporate officers, writing up corporate bylaws, holding regular shareholders’ meetings, and keeping minutes of significant company meetings.
S Corps are generally smaller businesses, as they must have 100 or fewer shareholders. Shareholders must be individuals, specific trusts or estates, or certain tax-exempt organizations (such as a 501(c)(3)).
Benefits of Becoming an S Corp
The biggest advantage of an S Corp is that they don’t have to pay federal taxes at the entity level. This can be especially beneficial to a business in its early years. In addition, an S Corp benefits from the following:
- Lower self-employment tax liability. S Corp business owners can lower their self-employment tax liability by designating the money they receive from the corporation as salary or dividends. They can also deduct business expenses and wages paid to employees.
- Personal asset protection. An S Corp’s shareholders enjoy the limited liability protection of the corporate structure — i.e., their personal assets cannot be accessed by creditors or legal claims against the company.
- Tax-free dividends. Shareholders can be company employees, earn salaries, and receive corporate dividends, which are tax free as long as the distribution doesn’t exceed their stock basis. If the dividends do exceed the shareholder’s stock basis, the excess is taxed as capital gains, which are taxed at a lower rate than regular income. (Note that S Corps must first pay reasonable salaries to shareholder-employees before any distributions are made.)
- Straightforward transfer of ownership. An S Corp can transfer interests or adjust property basis without facing adverse tax consequences or needing to comply with complex accounting rules.
- Cash method of accounting. While corporations with gross receipts over $25 million must use the accrual method of accounting, S Corps typically don’t have to use the accrual method regardless of their income (unless they have inventory).
- Higher Credibility. Having the status of an S Corp can help a business establish credibility with potential customers, employers, suppliers, and investors, as it shows the owner’s formal commitment to the company.
As with anything in life, there can be disadvantages to becoming an S Corp — such as greater IRS scrutiny due to the way employees are paid, stricter distribution rules, and limits on the number and nature of shareholders. But in most cases the benefits of becoming an S Corp outweigh any disadvantages.
How To File an S Corp Election
To file an S Corp election, a business has to meet certain IRS requirements, including:
- Being incorporated within the U.S.
- Having only one class of stock
- Having 100 or fewer shareholders
Also, shareholders must meet certain eligibility requirements: They must be individuals, specific trusts or estates, or certain tax-exempt organizations. Partnerships, corporations, and nonresident aliens do not qualify as eligible shareholders.
If a business meets these requirements, they are eligible to file as an S Corp. To do so, they must file Form 2553 (“Election by a Small Business Corporation”) with the IRS, and all shareholders must sign a consent statement.
S Corp Election Filing Deadlines
At this point in the year, we are past the deadline for filing an S-election for 2021, but the IRS does allow late filing if a company can show reasonable cause for it to be late.
Typically, corporations must file an S-election no later than 2 months and 15 days after the start of the tax year when the status will take effect (or at any time during the prior year). So, to be considered an S Corp for the 2021 tax year, you had to file the election by March 15th. However, the IRS will allow a late filing if you can show that a reasonable cause led to the delay, such as:
- Your company’s president, chief executive officer, or similar responsible person neglected to file the election
- Your corporation’s tax professional or accountant neglected to file the election
- Your corporation or its shareholders didn’t know of the need to file an election
- Your corporation or its shareholders didn’t know the election needed to be filed in advance
In addition, to request a late filing, you must not have filed a tax return for the tax year in question, and any shareholders whose tax returns will be affected cannot have filed their personal tax returns for the year (or cannot have filed a return that is inconsistent with the S Corp filing).
If this is the case and you can show reasonable cause for filing a late election, the IRS is typically pretty lenient in granting a late filing.
If you think your company may be eligible for a late filing for S Corp status for 2021, or if you are interested in moving your business to an S Corp for the 2022 tax year, contact Wood CPA for assistance. In addition to tax preparation services, we offer our clients a range of business accounting and business advisory services, and would be happy to help you determine if becoming an S Corp is the right move for your company.
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