12 minute read
S corporations only exist in the tax world. For legal purposes, S corporations and C corporations are the same; they are simply called corporations. But tax planning for C corporations will look quite a bit different than tax planning for S corporations, so make sure that you – and your tax planning software – understand the differences.
In general, taxpayers can form an S corporation in one of two ways: they can (1) establish a corporation and then make an S election, or (2) establish a limited liability company (LLC), elect for their business to be classified as a corporation, and then make an S election.
If you wish to establish a corporation, you should follow the formation steps outlined here.
If you wish to establish an LLC, you will follow the LLC formation steps as defined by your jurisdiction. These steps closely resemble the steps needed to establish a corporation, but with a few key differences.
Like corporations, partnerships, and sole proprietorships, LLCs must also register with government agencies to apply for payroll and/or sales tax identification numbers and to obtain business licenses.
From a legal standpoint, corporate entities are separate and distinct from their owners. This means that shareholders of a corporation are only liable for the business’s debts up to the amount of their investment. This fact holds true whether the entity is taxed as a C corporation or an S corporation.
LLCs offer similar liability protection. Like corporations, LLCs are separate and distinct from their owners, so LLC members are only liable for business debts up to the amount of their investment.
But LLCs may offer slightly better protections, and here’s why: if a shareholder is involved in a personal debt collection lawsuit, their stock shares can be used to fulfill that judgement. Once a creditor has control of those shares, they can make decisions that negatively impact other shareholders or even the corporation as a whole. LLC membership is treated differently. LLC ownership is not an asset that can be transferred in judgement proceedings. If creditors of an LLC member are seeking judgement, they can claim right to the member’s future distributions, but they cannot assume the membership/ownership itself.
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Making the S Election
By default, all corporations are taxed as C corporations. The tax laws governing corporations are outlined in Subchapter C of the Internal Revenue Code. To be considered an S corporation for tax purposes, the corporation must file Form 2553, Election by a Small Business Corporation, which will permit them to be taxed under Subchapter S of the Internal Revenue Code.
In contrast, an LLC will need to file two forms if they want to be taxed as an S corporation. First, they must file Form 8832, Entity Classification Election and select that they want to be classified as a corporation for Federal tax purposes. From there, they must file Form 2553, Election by a Small Business Corporation to make their S election.
Both tax forms are simple, but filing them timely is key.
Form 8832 can be filed at any point, but the new tax status of the entity will take effect no earlier than 75 days before the form is filed, and no later than 12 months after the form is filed. This 75-day window allows tax preparers to make a retroactive election on behalf of their clients.
Form 2553, the S election, has similar filing deadlines. They must be filed no later than two months and 15 days after the beginning of the tax year that the election is to take effect, or at any time in the tax year preceding the tax year the election is to take effect.
If you want both Forms 8832 and 2553 to take effect in the same tax year, you do not need to file them in any certain order. As long as you file them both within the time frames given, you should be safe. Let’s look at an example. Keep in mind that for ease of tax reporting, most business owners want to change their tax entity (or make an S election) as of the beginning of a tax year.
EXAMPLE:
ABC LLC, a multimember LLC, is taxed as a partnership in 2020 but would like to be considered an S corporation in 2021. To make their changes effective as of January 1, 2021, they must do the following:
Other Tax Concerns
S corporations are flow-through entities. The business reports its activity on an informational tax form, Form 1120-S, and the individual’s proportional share of business income, deductions, gains, losses, credits, and tax attributes flow down via Schedule K-1.
S corporations themselves will not have to pay taxes, but S corporation shareholders will need to pay estimated taxes for their share of business income in equal installments throughout the year.
What are the tax advantages of an S corp?
Well, S corporations actually have a few advantages for shareholders:
The owners are protected from personal liability.
It’s simple to transfer ownership.
There is only one level of taxation.
There is an option for the shareholder to be paid a salary and a distribution.
Unlike partnerships wherein partners are subject to self-employment taxes on their entire share of business earnings, S corporation shareholders only pay self-employment taxes on wages they receive from the business. Distributions they receive from their S corporation are not subject to self-employment taxes. Having the ability to shift payments between salary and distribution is a useful tax planning mechanism.
What are the disadvantages of an S corp from a tax perspective?
There are strict requirements to qualify as an S corporation.
Some of these requirements are:
The profit and loss allocation is inflexible.
The IRS will be looking out for “reasonable compensation.”
Shareholders must think about loss limitations.
There are a few loss limitations S corporation shareholders need to think about.
S corporation taxation is not inherently better than partnership, sole proprietorship, or C corporation taxation. Entity selection should be dependent on the facts and circumstances of your client’s business. Governance, liability, ownership options, business continuity, and so many other factors will be at play, as will tax compliance. To help you make the best entity selection, you can turn to a good tax planning software to help.
Our tax planning software at Corvee makes the entity selection process a bit simpler by showing you how your taxes would change if you operated as any of the four entities we discussed in this series. For example, you may be operating as a C corporation and considering making an S election. With the click of a button, you can see how that change will change both your business and individual tax liability.
See how Corvee allows your firm to break free of the tax prep cycle and begin making the profits you deserve.
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