Subchapter S Election (S Corporation)
Many newly formed businesses opt to file with the IRS under the subchapter s election. This allows businesses the ability to enjoy corporate benefits while enjoying benefits such as double taxation avoidance. This article will focus on the advantages and disadvantages that this entity type brings.
How are S Corporations formed?
The first step to forming an s corporation in the U.S. would be to file IRS form SS-4 - Application for Employer Identification Number. This form is used for new businesses to obtain an Employer Identification Number (EIN). This is also where a business in the U.S. elects which type of entity they will operate as. More specifically, you will need to look on line 9a. Below is a snapshot of the most current version of the form, line 9a.
As you can see, there is not an option for a business to choose the s corporation election. In order for a corporation to elect s corporation status, they must first be recognized by the IRS as a corporation. Therefore, they would need to file form SS-4 and choose the corporation box on line 9a.
Once a corporation has decided to pursue the s corporation status, they will need to file Form 2553 - Election By A Small Business Corporation. This form must be completed no later than 2 months and 15 days after the beginning of the tax which the election is to take effect, or, at any time during the tax year preceding the tax year it is to take effect. If form 2553 is not filed in a timely manner, businesses may still be able to apply for s corp election if they have reasonable cause of late filing. In order for a business to apply for the late election, they must file form 2553 and state “FILED PURSUANT TO REV. PROC. 2013-30.” on the top of the form.
Pass Through Taxation - One of the most talked about advantages that gets brought up is that s corporations are treated as pass through entities. This means that they do not have to pay the corporate tax rate of 21%. They instead, pass through any income to the shareholders. Doing this avoids the double taxation that comes with filing corporate income taxes.
Distributions not subject to self employment tax - Distributions which are made to shareholders via Schedule K-1 are taxed at regular rates but are not subject to self employment tax. This exclusion of self employment tax is where a lot of smaller businesses see a break compared to sole proprietorships and partnerships.
Limited Liability - One of the biggest issues with filing as a sole proprietor is that there is no distinction between a business owners personal accounts/obligations and the businesses accounts/obligations. This means that personal assets and bank accounts could be forfeited if the business were to be sued or owe money.
Separate tax returns - One often overlooked advantage that s corporations have is the fact that the businesses tax returns are filed separately from the owners individual income tax returns. This is beneficial in that it allows owners to show the financials of the business which is useful when attempting to sell the business.
Limitations - Certain limitations apply for who can file as an s corporation. S corporations must meet the following requirements:
- Be a domestic corporation.
- Have only allowable shareholders-Shareholders may be individuals, certain trusts, and estates and-May not be partnerships, corporations or non-resident alien shareholders.
- Have no more than 100 shareholders.
- Have only one class of stock.
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Owners must be paid a “reasonable” wage - Owners of s corporations must be paid with payroll check just as an employee would be. This compensation must be within what the IRS considers a reasonable wage, these wages are subject to Social Security and Medicare withholding.
Filing/paying for tax return work - S corporations will need to file an annual return with the IRS. Form 1120S - U.S. Income Tax Return for an S Corporation. In many cases, a return will also need to be filed for the state(s) which the company operates in. This can potentially lead to higher return preparation costs.
S corp Vs. Partnership Vs. Sole Proprietorship
To see how s corporations stack up to partnerships and sole proprietorships, take a look at this article: http://help.halontax.com/bookkeeping-help-and-more/taxes/s-corporation-vs-partnership-vs-sole-proprietorship