S Election Definition

Choosing the right business structure is a typical challenge for small business owners. This page will explain what you need to know about the S election definition and when it might benefit you.

What is the S Election?

If you’re starting a new business, you may know that you need to form a legal entity to have limited liability for the company’s obligations. Whether you choose a corporation (a “C Corp” by default), a limited liability company (LLC), or S Corporation (also called an “S Corp”) depends on how you prefer to pay taxes. 

The C corp pays federal income taxes at the entity level, while shareholders pay taxes on dividends and salaries. Often, this is called corporate “double taxation.” On the other hand, the LLC uses pass-through taxation, which is where the LLC pays no taxes at the entity level. Instead, taxes are “passed on” to the owners, who pay income taxes on any profits. 

The S election allows a corporation to use pass-through taxation. Plus, unlike the LLC, the S Corp can save owners money by allowing them to use a bifurcated tax rate. The S election means the owners will pay the individual income tax rate on their salary and a lower rate on capital distributions.

The S election business definition clarifies that the S Corp isn’t a separate business structure. You first need to register a corporation or LLC and then make the S election with the IRS. Some states automatically recognize the federal S election. Other states require you to file a state-level S election, while others don’t recognize S Corps.

S Election Benefits

One of the main advantages of the S election is that you may end up owing fewer taxes. Primarily, the S election means you won’t pay income taxes at the entity level. Secondly, the S election allows the owners to pay a potentially lower tax rate on distributions. 

Consider the income you are most likely to make from the business. Suppose you plan to pay yourself a reasonable salary and issue lots of distributions. In that case, the S Corp election means you’ll pay a lower tax rate on most of your income. If you plan to reinvest the money in the business and not take a salary, the S election might not benefit you as much. 

S Election Considerations

The S election has disadvantages, too. First, making the S election requires additional paperwork. Some states require LLCs to make corporate filings after making the S election. 

Another important consideration is that not every company can make the S election. The IRS has specific requirements or limits, including:

• The business must be formed in a U.S. state.
• The shareholders must be individuals, certain trusts, or estates (not partnerships, corporations, or non-resident alien shareholders).
• The business cannot have more than 100 shareholders.
• The business must only have one class of stock.
• Certain corporations are ineligible, including certain financial institutions, insurance companies, and domestic international sales corporations.

Also, it’s important to know what impact the S election will have on your state taxes. Consider these S election examples. 

In most states, you’ll be able to pay a lower tax rate on distributions at both the federal and state levels. If your state doesn’t recognize the S election, you won’t see any tax benefits at the state level. However, some states don’t have a state-level income tax, so the lack of S Corp status in that state won’t affect what you owe. 

Summary

The S election offers a lower tax rate on distributions and no income taxes at the corporate level.

We Can Help

Taxes can be a sore subject for small business owners. With our expert guidance, you’ll be prepared with an understanding of the S election definition. When you’ve decided that the S election is right for you, we can help. Our Business Formation Services help you easily and efficiently submit your formation documents. Plus, stay up to date with our Worry-Free Compliance Service that will keep your documents organized and remind you of important deadlines.