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WHAT IS AN S-CORP?

Once you’ve chosen to form an LLC or a Corp, you can then choose to make an S-Corp election.

An S-Corp is an election a business can choose to make whether they form an LLC or a C-Corp. Making your S-Corp election does not impact the personal liability protections that come with the formation of an LLC or corporation. It is usually done for tax advantages, but before you decide to make the S-Corp election, you need to understand the benefits and some of the limitations it may put on your corporation or LLC.

S-Corp elections for Corporations

There are a few differences between businesses that opt for an S-Corp election and those that form a C-Corp. without the election. For one, owners of an S-Corp can claim operational losses as part of their personal income should the business fail to turn a profit. An S-Corp can also help business owners avoid what is referred to as the "double taxation" issue impacting C-Corps.

 

With C-Corps, taxes are imposed on the profits at the corporate level. Then, when the profits (after payment of the taxes) are passed down to the owners, the owners also must pay taxes on their dividends. S-Corps are treated more like partnerships in that all profits or losses are passed through to the owners and aren't taxed at the corporate level. Thus, profits are only taxed once.

Ownership restrictions — S-Corps trade their tax benefits for strict ownership restrictions. They are limited to only 100 owners (or shareholders), and these individuals must all be legal U.S. citizens. Trusts and other subsidiary companies are not eligible to become part of the ownership structure. This can be a serious limitation, depending on the nature of the business and how it plans on generating its funding or financing. Finally, there can only be one class of shares in an S-Corp.

S-Corporation Election for Inc.s Pros

  • All the benefits of a C-Corporation

  • A possible lower tax rate by avoiding double taxation

S Corporation Election for Inc.s Cons

  • Limited ownership rules

  • Extra paperwork

  • Strict regulation

S-Corp elections for LLCs

Many people don’t know that LLCs can also make S-Corp elections.  After reading the prior section, you may wonder why an LLC would make that election given the primary benefit double-taxation avoidance with a pass-through entity is already the default for an LLC. Yet, an S-Corp election for an LLC can also provide additional tax benefits to an LLC.

By making an S-Corp election, the LLCs distributions (the passing of profits after payment of LLC expenses including payroll) are not treated or taxed as wage income to the owners. Let’s say, for example, that you own an LLC and the annual profits are $1M. Without an S-Corp election, the owner of the LLC would have to pay payroll taxes on the $1M worth of profits.  With an S-Corp election, the LLC owner only pays payroll taxes on a “reasonable” salary that gets paid to the owner.  Any distributions after the payment of a reasonable salary are free of those payroll taxes if done correctly.

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The same restrictions described above applicable to corporations also apply to LLCs, so there are some restrictions on an LLC that makes an S-Corp election. Also, if the owners aren’t paid reasonable salaries, the IRS can invalidate the S-Corp election requiring the payment of back taxes and penalties.

Filing — In addition to the typical incorporation documents, S-Corps must file a special form with the IRS, Form 2553. This can be a relatively complicated and time-sensitive process.

S-Corporation Election for LLCs Pros

  • All the benefits of an LLC

  • A possible lower tax rate by avoiding some payroll taxes for the owners

S-Corporation Election for LLCs Cons

  • Limited ownership rules

  • Extra paperwork

  • Strict regulation

  • Penalties if not properly implemented

The Takeaway
An S-Corp election is a great option for LLCs that are profitable and for corps that don’t plan on going public or having many shareholders. And if your business won’t reap the benefits of an S-Corp election, it may not be worth it as there are additional filing requirements. You may want to visit with a tax professional to determine which route is best for you.

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