Is it better to structure your business as a small business corporation (“S corporation” or “S corp”) or an LLC? What are the potential costs and benefits of electing to be taxed as an S corp? And what is an S corp anyway?
If you’ve wondered about any of these questions, read on because this article provides a general overview of S corps.
S Corps, In General
Let’s start with what an S corp is (and isn’t). An S corp is not a type of business entity, but a special tax election made available under Subchapter S of the U.S. Internal Revenue Code. So, unlike an LLC, LLP, corporation, or even a cooperative, an S corp is not created by filing a document with a secretary of state or similar agency to create a state-level entity.
Instead, both LLCs and corporations - provided they meet certain eligibility requirements (discussed below) - can make an election to be taxed under Subchapter S by filing Form 2553. There is no fee for filing Form 2553, but there are important consequences related to your business’s structure and formal requirements, as well as tax liability.FN1
While LLCs and corporations both can make the election to be taxed as S corps, their reasons for doing so are generally distinct.
LLC Tax Treatment
Let’s start with LLCs since they are, by a rather large margin, the most common state-level entity being created these days. LLCs are generally very flexible business structures and this is certainly true when it comes to their possible tax treatments.FN2
By default, an LLC with a single owner (“member”) is a “disregarded entity” for state and federal income tax purposes. This means that all income and losses are allocated to the member on his or her personal tax return (on a Schedule C attached to their Form 1040), and the entity itself neither pays income tax at the entity level nor files any report with the IRS.
LLCs with more than one member are, by default, taxed as partnerships. Partnerships are “pass-through” entities that have to file an informational report (Form 1065) with the IRS, but gains and losses are allocated pro rata to the members on their individual tax returns.
Corporate Tax Treatment
However, both single-member and multi-member LLCs can file a form with the IRS to elect to be taxed as either a C corporation (C corp) or an S corp. C corps are entities taxed under Subchapter C of the U.S. Internal Revenue Code, and it is the default tax treatment for corporations. Unlike pass-through entities, C corps are taxed at the entity level. This means that the corporation is taxed on its income and then its owners (“shareholders”) are taxed on their share of income that they receive as salaries, wages, or dividends.
This taxation at the entity level as well as on individual returns is what’s commonly referred to as corporate “double taxation” because the same income is taxed first at the corporate/entity level and then again when it is received as income by its shareholders. (For more information on the tax treatment of corporations, see the page on Colorado Corporations.)
"Electing to be taxed as an S corp, instead of a C corp, allows that business to avoid “double taxation” by being treated as a pass-through entity for income tax purposes..."
S Corp Tax Benefits for Corporations
So this brings us back to S corps. Generally, the reason that any business elects to become an S corp is to reduce its (or its owners') tax liability while maintaining the personal asset protection afforded by either a corporation or an LLC.
For businesses taxed as corporations, electing to be taxed as an S corp, instead of a C corp, allows that business to avoid “double taxation” by being treated as a pass-through entity for income tax purposes. Since the business is treated as a pass-through entity, income tax is not paid as an entity, but only on the personal returns of the owners. Moreover, in an S corp, business losses also flow through to the owners and can therefore reduce their taxable income.FN3
Furthermore, both C corps and S corps are allowed to take deductions not available to other businesses including for the health insurance expenses of employees as well as their salaries or wages (which are considered a business expense). But the dividends paid to shareholders are “after tax” and not deductible.
S Corp Tax Benefits for LLCs
At this point, careful readers may have noticed that an LLC is already either a disregarded entity (if single member) or a pass-through entity (if multi member) by default, so where is the potential tax advantage for LLC members in becoming an S corp?
In the case of an LLC the advantage is not in avoiding double taxation, since an LLC is not taxed as an entity unless it elects to be taxed as a C corp. But an LLC taxed as an S corp can avoid some employment taxes.FN4 This has to do with the way that LLC members (compared to the working shareholders of a corporation) receive their share of net profits from the business.
By default, an LLC – whether single- or multi-member – compensates owners through either distributions (more commonly), guaranteed payments (less commonly), or both. Regardless of the form of compensation, members will be liable for employment taxes on their share of business income (whether or not they actually receive it from the business).
The situation is different for S corps. Owners, whether shareholders or members, who work for any corporation are presumed to be employees of that business and, as a result, they should receive reasonable compensation for that work (whether in the form of a salary or wages).FN5 As with LLC compensation, employment taxes will be due on these salaries or wages.
But as owners these shareholders or members can also receive income from the corporation in the form of dividends. In contrast with their salary or wages, employment taxes are not paid on dividends, which are taxed as ordinary income or, sometimes, capital gains. Shareholders or members receive income from dividends according to their equity split or sharing ratios according to their ownership of the business.
As a result, S corp owners who work for the business can allocate part of their share of net profits as reasonable salaries or wages and receive the rest as a dividend.FN6 Since income received as a dividend avoids employment taxes, an LLC taxed as an S corp can reduce the tax liability of its owners by avoiding some of the employment taxes that otherwise would have to be paid on the net profits of the LLC.
"Since income received as a dividend avoids employment taxes, an LLC taxed as an S corp can reduce the tax liability of its owners by avoiding some of the employment taxes that otherwise would have to be paid..."
But, as already noted in passing, the compensation working owners of an S corp receive for their services must be “reasonable” – given the wages typical for that sort of work and the net income of the business. As a result, until a business is earning enough to provide reasonable compensation to its working owners and still have something left over, there will not be any employment-tax savings by electing S corp tax treatment.
Where there is a potential reduction in tax liability – for a corporation or LLC – an S corp may be a good choice. Just remember that if your business is organized as an LLC, your taxes will become more complex and you will need to set up tax withholding. Moreover, you will need to make sure your business meets, and continues to meet, certain eligibility requirements. So, what requirements must a business meet in order to make a valid S election?
S Corp Eligibility Requirements
Ownership Restrictions: In contrast to C corps or LLCs that can generally sell their stock or interests to anyone, S corps are much more limited in who can become an owner of the business. First, other business entities, like other corporations or LLCs as well as partnerships, cannot own stock or interests in an S corp.
Additionally, most trusts are also prohibited from becoming S corp stock or interest holders. However, nonprofits, certain trusts – like grantor trusts, qualified Subchapter S trusts, and electing small business trusts – as well as estates of individuals who had owned stock or interests in an S corp can all (continue to) be owners of S corps.
Finally, individuals who own stock or interests in an S corp must be U.S. citizens or lawful permanent residents. As a result, nonresident aliens are not allowed to become owners of an S corp.
Limited Number of Owners: Unlike C corps or LLCs which are potentially unlimited in their number of owners, S corps are generally limited to no more than one hundred (100) owners. There is a bit of wiggle room here, however, since family members can generally decide to be counted as a single owner of an S corp – at least for purposes of this limit. To qualify as a single owner, the family members should all be descendants of a common ancestor who is no more than six (6) generations back. But spouses, adopted children, and step children are all also permitted within a single family owner of an S corp.
Equal Treatment of Owners: In addition to having restrictions on who can become an owner, S corps are also required to treat their owners as economic equals.FN7 For corporations, this means that they must issue only a single class of stock. As a result, and unlike a C corp, an S corp cannot issue preferred stock that would prioritize certain owners at liquidation or give them priority or preference regarding dividends. The one difference that is permitted in terms of classes of stock is that an S corp can have both voting and non-voting stock without losing the S election – it is only economically that owners must be treated equally.
For LLCs with shares or interests, owners still be must treated as economic equals. This means that some members cannot be privileged with respect to dividends or distributions or have a higher priority at liquidation. As a result, income and losses must be allocated to each owner on the same basis as any other owner.
Domestic Company: An S corp has to be a domestic company that has been established under the laws of a U.S. jurisdiction. Furthermore, the company must be headquartered in the United States.
"The one difference that is permitted in terms of classes of stock is that an S corp can have both voting and non-voting stock without losing the S election – it is only economically that owners must be treated equally..."
Passive Income Restriction: An S corp cannot receive more than 25% of its income from passive investment. Passive income, or passive investment income, is defined as income from any activity in which the company did not materially participate. However, this general definition is applied somewhat differently in the context of S corps, so it is advisable to consult a tax advisor if you believe your business may generate significant income from passive investment.
Generally, this restriction only applies to a company if it is converting to an S corp without distributing its accumulated earnings or profits from a previous year to its owners.FN8 But where a company becomes an S corp and its passive income exceeds 25% of its annual income, it will be required to pay tax at the corporate rate of 21% on its passive income in excess of 25%. Furthermore, if an S corp receives more than 25% of its annual income from passive investment for three consecutive years, it will lose its status as an S corp and will instead be taxed as a C corp.
Fiscal Year is Tax Year: An S corp’s tax year must end on December 31st (the fiscal year) unless the company has a clearly established business purpose for ending its tax year on another date.
"If an S corp fails to meet these eligibility requirements, it will lose its S election and be taxed as a C corp for income tax purposes... and be required to pay tax at the corporate/entity level..."
Unanimous Consent of Owners: In order to be taxed as an S corp, all of the company’s owners must consent in writing to the election.
Failure to Meet Eligibility Requirements
If an S corp fails to meet these eligibility requirements, it will lose its S election and be taxed as a C corp for income tax purposes. This means that it will be required to pay tax at the corporate/entity level for all business income and then owners will be taxed again for any dividends that they receive. This is precisely the sort of double taxation that the S election was intended to avoid. So it is important to understand these requirements and ensure they are continually satisfied.
Finally, it is important to understand that corporations that become S corps are still organized as corporations (despite their pass-through tax treatment). This means that S corps must elect a board of directors to oversee the management of the company and to appoint officers who oversee the day-to-day operations of the business. S corp owners must also hold annual shareholders meetings and maintain minutes for those and board meetings in the corporate records.
LLCs generally do not have to maintain all of these formalities, but they will need to make sure that their operating agreements are designed for S corps. This includes meeting certain conditions that are generally not required for LLCs that do not elect to become S corps, such as making sure that members are treated equally and that transfers to potential members that would invalidate the S election are restricted.
Tax Benefits vs. Investment Potential
While S corps can provide important tax benefits, they may also make it harder for a business to attract outside funding and investment. As a result, S corps may have a harder time raising capital than C corps. For example, the limitations on who can become a shareholder will mean that some potential investors will be unable to purchase stock in an S corp. Certain business entities or nonresident aliens may want to invest in your business, but their doing so would invalidate an S election so they could not become owners of an S corp.
Additionally, the fact that owners must be treated equally means that preferred stock cannot be issued by an S corp. Generally, multiple classes of stock are issued in order to attract certain investors who may demand priority or preference for their investment. These difficulties are compounded by the fact that S corps are generally limited to 100 owners and, as a result, may have to require individual investors to provide more capital than would be necessary if ownership was not limited in this way.
As a result, the eligibility requirements of S corps may make it more difficult to raise the capital that your business needs to grow or operate. Each business owner should carefully consider this limitation as well as potential tax benefits in order to determine what would work best for that owner’s business and its needs.
If you would like to discuss the particulars of your situation and whether an S corp is a good fit for your business, please Reach out, Today!
This article provides only general information and is not intended to be a substitute for legal advice.