Close search field

Blog

Tax Planning for S Corporations Using Tax Planning Software

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.

Formation

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 your client wishes to establish a corporation, they should follow the formation steps outlined here.

If your client wishes to establish an LLC, they will follow the LLC formation steps as defined by their jurisdiction. These steps closely resemble the steps needed to establish a corporation, but with a few key differences.

  • LLCs file Articles of Organization while corporations file Articles of Incorporation.
  • LLCs establish operating agreements whereas corporations establish bylaws.
  • LLCs and corporations both have business owners, but LLC owners are called “members” and corporation owners are called “shareholders”.
  • LLCs assign ownership to members in their Articles of Organization, whereas corporations assign ownership to shareholders when they issue company stock.

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.

Liability

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.

Taxes

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:

  • File Form 8832 sometime between January 1, 2020 and March 16, 2021, and
  • File Form 8832 sometime between January 1, 2020 and March 15, 2021

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.

Advantages

S corporations have a few advantages for shareholders.

The owners are protected from personal liability.

S corporation shareholders will only be liable for business debts in the amount they have invested in their stock shares.

It’s simple to transfer ownership.

S corporations can easily sell their shares to divest themselves of ownership in the business. LLCs taxed as S corporations will have a slightly more difficult time transferring ownership, but most Articles of Organization permit transfers of ownership. If your clients own an LLC, you should make sure their Articles of Organization address how to sell ownership interest.

There is only one level of taxation.

When making an S election, the business is no longer subject to double taxation. Business revenues will be taxed only once: at the individual level.

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.

Disadvantages

S corporations also have a few disadvantages.

There are strict requirements to qualify as an S corporation.

Some of these requirements are:

  • There must be 100 or fewer shareholders
  • Only individuals and certain estates, trusts, and tax-exempt organizations can be shareholders
  • There can only be one class of stock

The profit and loss allocation is inflexible.

S corporations must allocate profits and losses to shareholders based on ownership percentage. In contrast, partnerships can allocate profits and losses in almost any manner they choose, regardless of ownership percentage, giving them greater flexibility for tax planning.

The IRS will be looking out for “reasonable compensation.”

To ensure S corporation owners pay their fair share of payroll taxes, the IRS will make sure that compensation paid to shareholder-employees is reasonable for the industry, experience, and job duties. 

Shareholders must think about loss limitations.

There are a few loss limitations S corporation shareholders need to think about.

  • Stock and debt basis limitations
  • At-risk limitations
  • Passive activity losses
  • Excess business losses

Next Steps

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 your clients 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 client’s taxes would change if they operated as any of the four entities we discussed in this series. For example, your client may be operating as a C corporation and is considering making an S election. With the click of a button, you can see how that change will change both their business and their individual tax liability. If you want to learn more about our tax planning software, reach out to us today and request a demo.

Use Corvee Tax Planning software to help your clients select the right entity type.

Want to Learn More?

Please fill out the form below.

  • This field is for validation purposes and should be left unchanged.

Interested in Partnering?

Fill out the form below, and we’ll be in touch.

  • This field is for validation purposes and should be left unchanged.

Want to Learn More?

Please fill out the form below.

  • This field is for validation purposes and should be left unchanged.

Want to Learn More?

Please fill out the form below.

  • This field is for validation purposes and should be left unchanged.

Want to Learn More?

Please fill out the form below.

  • This field is for validation purposes and should be left unchanged.

Want to Learn More?

Please fill out the form below.

Read about how tax and accounting firm owners can help clients prepare for tax hikes in 2021.