Learn how an S corporation pays taxes, why it can be beneficial to pay taxes this way, how to select S corporation status, and some pros and cons of S corporations.
What Is an S Corporation?
S corporations are corporations that decide on an alternate way to pay yearly income taxes. Instead of the corporation paying the tax itself, the company’s income, losses, deductions, and credits are paid by the owners. Limited liability companies (LLCs) may also elect taxation as an S corporation.
Alternate names: Small business corporation, subchapter S corporation, S corp
How Does an S Corporation Work?
An S corporation operates like any other corporation—it has bylaws, shareholders, and a board of directors. The only difference is in the way the S corp pays taxes. A corporation pays income taxes at the corporate tax rate of 21% on its retained earnings (profits kept in the business). With S corp tax status, the owners (shareholders) pay the corporation’s taxes through their personal tax returns (called pass-through taxes). To report income taxes, the S Corporation files an information tax return using Form 1120-S. The S corporation also files a Schedule K-1 for each owner with the Internal Revenue Service (IRS). The Schedule K-1 form shows how much annual income the owner received from the business, and this income is used to calculate the owner’s total income tax bill.
Requirements for an S Corporation
“There are two paths to becoming an S corporation, one for a business that is a corporation and one for LLCs,” Rosen said via email. “Both paths include a process called an ‘election’ to be taxed as an S corporation.” Before becoming an S corporation, a business must meet specific tests. The potential S corporation must:
Be a domestic corporation (registered within the U.S.)Have no more than 100 shareholdersHave shareholders that are persons, estates, or trustsNot have partnerships, corporations, or non-resident alien shareholders Only have one class of stock (common stock)
After ensuring that they meet the requirements, the company must then file a form with the IRS to choose S corporation status.
Corporations: A corporation elects S corp status by submitting a Form 2553 Election by a Small Business Corporation to the IRS. LLCs: An LLC elects S corp tax status by filing Form 8832 Entity Classification Election as well as Form 2553. There is no need to change from an LLC to a corporation to make this election. Sole proprietor: A sole proprietor would need to become a corporation or LLC before electing S corporation tax status.
The company must make the election no more than two months and 15 days after the beginning of the tax year when the election is to take effect, but it can also make the election at any time during the year before. For example, let’s say your company’s tax year ends on December 31. If you started the business on Jan. 1, 2020, and you want to make the election in 2020, you must do it no later than March 15, 2020. If you want to make the election for 2021, you can do it any time in 2020, but no later than March 15, 2021.
Pros and Cons of S Corporations
Pros Explained
Limited liability for owners: S corporations, like LLCs and corporations, are separate legal entities, which means owners have limited liability for the S corporation’s debts and lawsuits—as long as they follow IRS rules. Additional tax deduction for owners: S corporation owners, like owners of LLCs, may be eligible for a 20% qualified business income (QBI) deduction from their share of the S corp income. This benefit is in addition to the normal tax deductions the business takes. Corporate owners aren’t eligible for this benefit. Avoids double taxation for owners: Most businesses form an S corporation to avoid the double taxation dilemma of businesses formed as corporations. Double taxation for a corporation means that owners are taxed twice—once on the income of the business and again on income distributed to owners in the form of dividends.
Cons Explained
Only allows for one type of stock: Only one type of stock is allowed for S corporations, and there are restrictions on types of owners. These limitations don’t apply to corporations. Limited tax year options: An S corporation must have a December 31 fiscal year-end unless it has a good reason for a different year-end and gains approval from the IRS. IRS oversight of owner pay: The IRS watches closely to see that S corporation owners working in the business are being paid reasonable compensation for their services as employees so they can’t avoid paying taxes. S corp owners must also report and pay their share of FICA tax (Social Security/Medicare) on this income.
