Guide to Start an S Corp Election

What is an S corp?

S corporation, commonly referred to as S corp, refers to a tax status available to qualifying LLCs and corporations. It can have substantial tax benefits, depending on a variety of factors. First, you should understand that an S corporation is not a business structure like a sole proprietorship or a separate legal entity like a corporation or LLC. Rather, it’s a tax classification that either an LLC or a corporation can apply for with the Internal Revenue Service (IRS) if it meets the criteria. We’ll outline those criteria and the steps you would need to take to file as an S corporation if you decide that it’s right for your business.

For a limited liability company (LLC), filing as an S corporation may provide savings on self-employment taxes in some cases. For C corporations (the default form of corporation), it can be a way to avoid double taxation. While both S Corps and LLCs offer limited liability protection, there are other key differences in taxation and ownership structures that businesses should consider. See S Corps vs LLCs or S Corps vs C Corps for detailed comparisons.

Requirements and Considerations of S Corps

Before we go over how to form an S corporation, you should be aware of the requirements and limitations for filing as an S corporation. To qualify for S corporation status, the IRS says your business must:

• Be a domestic corporation or LLC
• Have no more than 100 shareholders or members  (“shareholders” is the term for owners of a corporation, while “members” is the term for owners of an LLC)
• Have only one class of stock
• Not be an ineligible corporation, such as certain financial institutions, insurance companies, and domestic international sales corporations
• Have only allowable shareholders or members, which includes individuals, certain trusts and tax-exempt organizations, and estates. The shareholders may not be partnerships, corporations, or non-resident aliens. A nonresident alien is an alien who has not passed the green card test or the substantial presence test.

Does your business fit these requirements? If so, keep reading and learn how to create an S corporation.

Filing Form 2553 to start an S-Corp

To apply for S-corp status, you’ll first need to create either an LLC or a corporation, if you haven’t already done so. Then, you’ll file an election Form 2553 with the Internal Revenue Service (IRS).

How to Set up an S Corp Election from an LLC

To read more details of each step, see our How to Start an LLC page.

How to Set up an S Corp Election from a Corporation

To read more details of each step, see our How to Start a Corporation page.

Final Step – File form 2553 to apply for S corporation status

Submit the form to apply for S corporation status. Once your LLC or C corporation formation is approved by the state, you need to file Form 2553, Election by a Small Business Corporation, to get S corporation status. 

The Internal Revenue Service requires that you complete and file your Form 2553 with the IRS: 

• Within 75 days of the formation of your LLC or C corporation, or no more than 75 days after the beginning of the tax year in which the election is to take effect

OR

• At any time during the tax year preceding the tax year the election is to take effect.

One note for LLCs wishing to file as an S corporation: If your LLC is past the 75-day election deadline, you’ll also need to file Form 8832, Entity Classification Election, to elect to be taxed as a corporation. Then you would file both Form 8832 and Form 2553 together via USPS-certified mail. 

The IRS has more information on when and how to file Form 2553 and other information about how to set up an S corporation on its website.

Additional Steps on Forming an S-Corp

Whether you’re forming an LLC or a corporation, it’s important to know that not every state follows the same process. For example, most states follow the five steps below for forming an LLC, but three states (New York, Arizona, and Nebraska) also have a publication requirement. California and West Virginia also have additional steps for LLC formation. Our instructions above for forming an LLC generally apply to most states, though.

Also, know that some states use different terms for essentially the same thing. For example, most states use the term “registered agent,” but others may refer to this as a “statutory agent,” “resident agent,” etc. “Articles of Organization” also goes by different names.

Pros and Cons of Filing

While S corporation classification does come with a number of benefits for some businesses, making this election might not be right for all business types. So, be sure to carefully weigh the various pros and cons before deciding how you want to move forward. Consult a tax professional about whether the S corporation election would be best for your business.

LLC with S Corp Election Advantages:

The advantages of filing as an S corporation for a limited liability company aren’t exactly the same as they are for C corporations. Let’s look at the advantages for LLCs first.

Self-Employment Taxes Explained

A traditional LLC already has pass-through taxation, so the benefits of S-corp election for an LLC have to do with self-employment tax. This requires some explaining, but for certain LLCs, it could save a lot in taxes.

The members of a standard LLC are considered self-employed. They’re compensated by receiving their share of profits from the LLC, but they can’t be employed by the LLC. Being self-employed means paying self-employment taxes (Social Security and Medicare, which adds up to about 15.3%) on all profits they receive from the LLC. This is more than the taxes they’d pay when working for someone else because their employer would pay part of them.

Dividing Salary and Profits

But when the members elect S corporation status, they can be compensated in two ways, by receiving their share of the profits and by being paid as an employee. Once they do that, they only pay Social Security and Medicare taxes on their salary and not the profits they receive.

Depending on factors such as how profitable your company is, the tax benefits could be substantial. (Of course, the members will still pay income tax and all other applicable taxes on their share of the profits; we’re only talking about the taxes that would go toward Social Security and Medicare here.) Money paid out as salary is a tax-deductible expense for the business. 

Reasonable Compensation

One caveat to this is that the IRS expects you to pay yourself a “reasonable salary” as an employee of the LLC. Otherwise, you could pay yourself an annual salary of $1 and avoid contributing anything to Social Security and Medicare. 

So, what is “reasonable compensation”? The instructions on Form 1120-S read, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” Basically, the IRS considers “reasonable” to be something similar to what others in your field are earning.

If the IRS determines that your salary isn’t reasonable, it has the authority to reclassify your non-wage distributions (which aren’t subject to employment taxes) to wages (which are subject to employment taxes). Several court cases have supported the IRS’s right to do this.

LLC with S Corp Election Disadvantages:

Having an LLC with S corp status can also have some drawbacks over a regular LLC:

Stricter Requirements 

As we listed above, S corps must adhere to more regulations than a standard LLC or C corporation. An S corp can have no more than 100 members, and none of them can be partnerships, corporations, or non-resident aliens. A traditional LLC doesn’t have these limitations.

More IRS Scrutiny

Because of the above restrictions and the requirements about paying yourself a “reasonable salary,” the IRS tends to monitor LLCs filing as S corps more closely. That could mean a greater chance of being audited, even if you follow the law to the letter. In fact, S corp owners may want to observe many of the same formalities that C corporations do (such as regular meetings and extensive record keeping), even if they’re not legally required to.

Additional Accounting and Bookkeeping

Having an LLC that files as an S corporation generally means more paperwork. If you don’t already have to do payroll for your business, being an owner-employee means that you’ll have to do so. Your taxes will be more complex, as well.

With these added complications, you’re likely to have higher administrative costs. You may find that you need an accountant, bookkeeper, and/or a payroll service or software.

C Corporation with S Corp Election Advantages:

If you have a C corporation (the default form of corporation), filing as an S corp does have its advantages:

Pass-Through Taxation

A big disadvantage for traditional corporations is “double taxation.” When the corporation makes money, the IRS taxes those profits on the corporate level. Then, when those profits are ‌distributed to the individual owners (shareholders) as dividends, they’re taxed a second time on the shareholders’ personal income tax returns.

But when a C corporation qualifies to be an S corp, those profits are only taxed at the individual level. The business itself isn’t taxed on them. This is called “pass-through taxation” because it allows you to pass corporate income through to the shareholders without first being taxed at the corporate level. This is how sole proprietorships and general partnerships are taxed. LLCs are also taxed this way unless they choose to be taxed as a corporation.

We need to add here that, since the 2017 Tax Cuts and Jobs Act, the corporate tax rate has been lowered to a flat 21%. So, the disadvantages of double taxation aren’t as severe now as they were. 

Writing Off Losses

Just as business profits pass through to the owners of an S corp, so do the losses. Unlike the shareholders of a C corporation, S corp owners can write off the company’s losses on their personal income statements. 

This can help offset their income from other sources and can be helpful if the corporation loses money in the first couple of years. Still, make sure you’re aware of ​​the IRS’s shareholder loss limitations.

Qualified Business Income Deduction

Under the Tax Cuts and Jobs Act, some S corporation owners may be able to deduct up to 20% of their qualified business income. This deduction isn’t available to C corporation shareholders.

Qualified business income (QBI) is basically your share of the company’s profits, or, as the IRS puts it, “QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts.”

The IRS website has a detailed explanation as to what is and is not included in QBI. There’s an income threshold that, if exceeded, may reduce your QBI (see the IRS website for details).  

C Corporation with S Corp Election Disadvantages:

An S corporation status also has its downsides for C corporations:

Limited Number of Shareholders

As we said, an S corp can’t have more than 100 shareholders, while a C corporation has no such restriction. That limitation could be an issue later if the corporation expands and goes public.

Limited Types of Shareholders

All S corp shareholders must be U.S. citizens, or certain trusts or estates. That could limit your ability to expand internationally. You also can’t have partnerships or corporations as shareholders. C corporations don’t have these limitations.

One Class of Stock

One way corporations attract investors is to offer preferred stock. That’s fine for C corporations, but the IRS doesn’t allow it for S corporations.

More IRS Scrutiny

Because of the extra restrictions S corps have, the IRS watches them more closely to see if they’re in compliance. In other words, your corporation is more likely to get audited.

We can’t stress enough how important it is to have tax guidance about your specific situation from a qualified tax professional. An accountant with S corp experience should be able to make sure you stay in compliance with the Internal Revenue Code, but they may also be able to help you find additional tax savings.

How S Corporations Can Save Money on Self-Employment Taxes

Joe has an LLC without S corp election.

Jill has an LLC with S corp election.

Both LLCs make $200,000 in profits.

Joe takes all of his LLC’s earnings ($200,000) as a distribution.

With an S corp, Jill is able to split the $200,000 in profits into two groups, her salary ($100,000) and the distribution she receives as the LLC owner ($100,000).

Joe must pay self-employment taxes (Social Security and Medicare) on the full distribution at 15.3%. $200,000 x 15.3% adds up to $30,600.

Jill pays self-employment taxes on her $100,000 salary at 15.3%, adding up to $15,300. Because Jill’s LLC is an S corp, she pays no self-employment taxes on the $100,000 she receives as a distribution.

Final amount of self-employment taxes paid by Joe: $30,600.

Final amount of self-employment taxes paid by Jill: $15,300.

S Corps and State Taxes

An S corp filing is done with the IRS for federal tax purposes, but what about state taxes? Does the pass-through taxation also apply to those, too?

Most states recognize the S corp status for state tax purposes. In other words, if the business entity itself doesn’t pay federal corporate income tax, it usually wouldn’t pay state income taxes, either. The profits would only be taxed on the personal income tax returns of the shareholders or members. 

However, there are some states and jurisdictions that don’t recognize the S corp status. In those areas, your S corp would pay state taxes just as a C corporation would. Also, a few states have taxes that are applicable specifically to S corporations.

Most states don’t require you to make a separate S corp election at the state level, but several do. For those states, you would need to complete a separate form to be taxed as an S corp for state taxes.

How We Can Help

Forming a business can be complicated, but we’re here to make it as easy for you as possible.

When you’re ready to take the leap, we can help you form an LLC with an S corporation designation and provide you with valuable support for all of your business needs moving forward. Click the button below to get started.