If your business is currently structured as an LLC or a C Corp, you may be wondering if you should switch to an S Corp. An S Corp election may be worth it for the tax benefits, but it does require more paperwork and ongoing obligations. Understanding the advantages and drawbacks, as well as how to fill out Form 2553, will help you determine whether or not it’s right for your business.
Eligibility overview
Corporations and LLCs can file Form 2553 and elect to be taxed as an S Corp, but they must meet the following requirements:
- Be a domestic corporation operating in the United States.
- Have no more than 100 shareholders—you can treat an individual and their spouse as a single shareholder. You can also treat all members of a family as one shareholder to meet this requirement.
- All shareholders are individuals, estates, or exempt organizations, like nonprofits.
- All shareholders are either U.S. citizens, permanent residents, or resident aliens.
- You only have one class of stock, not multiple classes with different rights.
- Your business isn’t a bank, financial institution, insurance company, or domestic international sales corporation.
- Your business has a calendar year ending on December 31.
Pros and cons to consider
Many business owners adopt the S Corp structure to take advantage of the tax benefits. Unlike C Corps, S Corps don’t pay taxes at the corporate level, and any business income or losses are “passed through” to its shareholders. Shareholders then report these earnings or losses on their personal tax returns.
And if your business is currently an LLC, switching to an S Corp can reduce your self-employment tax. LLC owners pay the full 15.3% self-employment tax, while S Corp owners only pay it on their designated salary. The remaining funds can be withdrawn as distributions.
For example, let’s say your business brings in $100,000 annually. You decide to pay yourself a $60,000 per year salary and take out the remaining $40,000 as distributions. Your salary is subject to income and self-employment taxes, but the distributions aren’t subject to any self-employment taxes. In comparison, if your business were taxed as an LLC, the full $100,000 would be subject to self-employment taxes.
However, switching to an S Corp puts more restrictions on your stock and shareholders. It may come with more compliance requirements, like filing an annual report or other tax filing requirements. It can also lead to closer scrutiny from the IRS, especially regarding the reasonable salary requirement.
Filing deadlines and late election relief
The deadline for existing businesses to switch to make an S Corp election for that tax year is March 15. New businesses have 75 days after their start date. However, if you miss the deadline, you may qualify for late election relief.
Your business may qualify for late election relief if it meets the following requirements:
- Your business meets the eligibility requirements for S Corp status.
- You have reasonable cause for filing late, like incorrect advice from your accountant.
- You can demonstrate that you intended to make this election from the beginning of the year.
- You meet the late filing deadline, which is three years and 75 days from the date you originally wanted the S Corp status to take effect.
Making the jump to an S Corp comes with many benefits, but there are ongoing obligations you need to be aware of. For many people, the biggest change is that you’ll have to start paying yourself a reasonable salary.
Completing IRS Form 2553 step by step
When you’re filling out Form 2553, it’s important to be accurate since even small errors could cause the IRS to reject your application. Here’s how you’ll fill out the tax form:
- Business info: In Part I, you’ll provide some basic information about your business, like the business name, address, and employer identification number (EIN). You’ll also include the date your business was incorporated and details about any shareholders. The tax form must also be signed and dated by an authorized officer, like a president, vice president, or another corporate officer.
- Get consent from shareholders: All shareholders must consent to the S Corp election, so you’ll need to have each one sign either column K of Form 2553 or an attached document.
- Fiscal year choice: You only need to complete Part II if you checked Box 2 or 4 in Part I, item F. Most businesses use a calendar year that ends on December 31, so only choose a fiscal year if you have a valid business reason.
- Qualified Subchapter S Trust: A Qualified Subchapter S Trust is a specific type of trust that’s allowed to own stock in an S Corp. This section won’t apply to most businesses, but if you think it does, you’ll want to reach out to an accountant for assistance.
- Late election statement: If you’re filing Form 2553 before the deadline, you can skip this section. If you’re filing late, then you’ll sign Part IV to signify you meet the eligibility requirements listed.
You can’t electronically file Form 2553—instead, you’ll have to mail it directly to the IRS. After you’ve filed, the IRS should send you a letter telling you whether or not they’ve accepted your S Corp election within 60 days.
State-level follow-ups after election
Whether you have to follow up at the state level after an S Corp election really depends on your state. Many states accept your S Corp election for state tax purposes, and no further action is needed. But some states, like New York, do require a separate state election. You can learn what the requirements are in your state by either checking the state’s Department of Revenue website or consulting with your accountant.
Payroll and owner-comp requirements
Making the jump to an S Corp comes with many benefits, but there are ongoing obligations you need to be aware of. For many people, the biggest change is that you’ll have to start paying yourself a reasonable salary. The IRS doesn’t specify what’s considered reasonable, but it usually looks at factors like your duties, time and effort, and comparable salaries for others in your industry and location.
If the IRS believes you set your salary too low, it can re-classify previous dividends as wages and add back payroll taxes and other fines. To avoid these kinds of penalties, spend some time researching the average compensation rates on sites like Payscale, Glassdoor, and the Bureau of Labor Statistics.
Because you’re paying yourself a salary, you’ll also owe payroll taxes each month. Fortunately, you can manage your salary, track your W-2, and pay your payroll taxes with software like QuickBooks or Gusto.
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