There is some confusion surrounding the S Corporation Election and what it means for businesses. What is an S Corporation, and how is it different from a C Corporation? When should a business file taxes as an S Corporation?
This guide aims to alleviate some of this confusion and help business owners determine whether to choose the S Corp Election.
What Is an S Corporation?
An S Corporation isn’t a business entity; it’s a tax election at the federal level. To become an S Corp for tax purposes, business owners must first register their company as either an LLC or Inc. Then, if they meet eligibility requirements, they may elect to become an S Corporation for federal tax purposes.
IRS S Corp Eligibility Requirements
The IRS has certain eligibility requirements for S Corporations. Here’s a summary; you can find more information on the IRS website.
To quality, the company must:
- Be a domestic (USA) corporation
- Be individuals, certain trusts, and estates
- Not be corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Double-Taxation for C Corporations
A C Corporation is a separate legal and tax-paying entity from its owners. C Corporations offer the highest level of personal liability protection to shareholders. There are no limitations to the number of shareholders a C Corp may have.
A C Corp’s profits and losses are reported on the business’s corporate tax return. Taxable income is subject to the corporate federal income tax rate.
Double taxation may occur when a corporation pays dividends to its shareholders. These dividends aren’t tax deductible, so the C Corp pays income tax on these profits, then the shareholders also pay tax on the same income via their personal tax returns.
S Corp Election for C Corporations
A business can avoid double taxation if it uses an S Corp status for federal taxes. There are pros and cons to this election. C Corp shareholders may benefit from an S Corp if they want to retain personal liability protection but avoid possible double taxation. Because each business is unique, owners should consult an expert for professional guidance when making this decision.
Taxation for LLCs
A Limited Liability Company is a separate legal entity from its owners and provides personal liability protection. However, the IRS does not recognize an LLC as its own entity for tax purposes. An LLC start out as either a 1-owner disregarded entity, or with 2 or more partners as a partnership.
All business profits and losses flow through the LLC to its members’ personal tax returns. The company’s taxable income is subject to self-employment taxes (FICA, aka Social Security and Medicare taxes) and income tax.
S Corp Election for LLCs
If an eligible LLC elects S Corporation taxation status, the income paid to LLC members via payroll is subject to Social Security and Medicare taxes, but profits paid as distributions are not.
This often helps LLC members lower their personal tax burden. However, the company must pay its owners reasonable compensation for their work or risk raising a red flag with the IRS.
There’s a lot to consider in 2021 regarding S Corporations, C Corporations, LLCs and business taxes. We urge business owners to contact a professional for assistance before making any decisions regarding business entities and federal tax elections.
To discuss your individual circumstances, contact Insogna CPA for guidance on what would best benefit your organization.