S corporations (S-corps) are pass-through entities that don’t pay federal income taxes. Rather, their profits, losses, deductions, and credits pass to their shareholders’ tax returns. The shareholders are then responsible for paying federal income taxes on their share of the S-corp’s income based on their individual income tax rates. Since S-corps are not taxed at the entity level, they are often an attractive option for many small business owners.
Key Takeaways
- S-corps are formed by filing Form 2553
- S-corps file an annual IRS Form 1120-S to report their income and deductions
- S-corps can have a maximum of 100 shareholders
- S-corps must set up a payroll system and pay payroll taxes
S-corp Requirements
To make an S-election, an S-corp must meet the following requirements:
- Be a domestic corporation.
- Have no more than 100 shareholders.
- Have only one class of stock.
- Have no shareholders that are partnerships, limited liability companies (LLCs), or certain trusts.
- Adhere to certain operational and reporting requirements, such as holding annual shareholder meetings and filing annual reports.
S-corps must be careful to always pay shareholder distributions proportionally based on the number of shares owned. If one shareholder receives more distributions per share than another, a second class of stock has been formed, and the business could lose its S-status.
Tax Treatment of S-corps
As an owner or operator of an S-corp, the tax treatment of your income depends largely on whether you receive a distribution from the S-corp or receive wages. While S-corps don’t pay income taxes directly, there are a few S-corp taxes that you should know about like built-in gains tax and excess net passive income tax.
For shareholder distributions beyond wages, you won’t have to go through the hassle of running payroll. Distributions can simply be checks written to the shareholder directly from the company checking account.
Meanwhile, as a shareholder-employee, you must receive wages from the corporation for the services you perform. Your pay must be what the IRS deems to be reasonable wages. What is considered reasonable wages depends on several things, such as the employee’s skills, experience, duties, and responsibilities, and the company’s size, business, and location.
One way to determine reasonable compensation is to look at what similar businesses pay their employees for similar work. Another method is to use the United States Bureau of Labor Statistics’s National Wage Data to set a reasonable salary for yourself and/or your employees.
S-corp Payroll Requirement
Once you have met the legal requirements to make an S-election, you’ll need to set up a payroll system to pay yourself and other employees. There are several steps that must be taken for S-corp payroll requirements to ensure that federal and state rules are being followed. These include:
- Step 1: Setting a reasonable salary. S-corp shareholder-employees must earn a salary that’s comparable to what similar businesses pay their employees for the same type of work.
- Step 2: Calculating payroll and taxes. Once you’ve determined your salary, you should divide the annual figure by the number of pay periods, such as monthly or quarterly, to calculate your payroll. You must also withhold Social Security, Medicare, and federal income taxes from their paychecks and remit those taxes to the IRS regularly.
- Step 3: File payroll tax returns. S-corps must file quarterly payroll tax returns with the IRS and state tax authorities. These returns report the total wages paid to employees, the amount of payroll taxes withheld, and the amount of employer payroll taxes owed. To report and file your payroll taxes, you’ll need IRS Form 941. You can learn how to fill out this form via our guide on Form 941 Instructions, where we cover how to complete each part.
- Step 4: Keep accurate records. S-corps must keep accurate records of all payroll transactions, including employee pay stubs, payroll tax returns, and other payroll-related documents.
S-corp Filing Requirement
As the owner and operator of an S-corp, you must file IRS Form 1120-S, U.S. Income Tax Return For an S Corporation, where you’ll report the S-corp’s income, deductions, and credits. Part of the Form 1120-S is Schedule K-1, which shows each partner’s share of the company’s income, deductions, and credits. This must be included in the shareholder’s personal tax return. If you need guidance preparing Form 1120-S, take a look at our guide on how to complete Form 1120-S & Schedule K-1.
The due date for Form 1120-S is March 15, which is the 15th day of the third month after the end of the tax year. S-corps can ask for more time to file the return by filling out IRS Form 7004. This gives you until September 15 to file the return.
In addition to federal taxes, S-corps may also have to file state and local tax returns, depending on the state where the business is located. S-corps may have to file state tax reports and pay state franchise taxes, or other state fees or taxes.
How To Form an S-corp
- Step 1: Choose a name for your business and check with the Secretary of State’s office in your state to see if it is already taken. The name shouldn’t sound too much like the name of another business in your state. To learn more about how to create a business name.
- Step 2: Register your company with the Secretary of State in your state as an LLC or corporation. Your company’s name, address, and mission statement should all be included here. For assistance, visit our guide to the best online legal services including IncFile for free business registrations.
- Step 3: Obtain all state and municipal business licenses and permissions that may be required.
- Step 4: Obtain an employer identification number (EIN) from the IRS. This is a unique nine-digit number that identifies your business for tax purposes. For guidance, refer to our guide on how to get an EIN.
- Step 5: File IRS Form 2553 to elect S-corp status for your corporation. This form must be filed within 75 days of when you’d like the election to be effective, usually the first day of your first year for new corporations. If you’ve missed the deadline, attach Form 2553 to your initial Form 1120-S within three years and 75 days of the desired S-corp election date. Read our guide to filing Form 2553 for more help.
If you’re filing late by attaching the Form 2553 to your Form 1120, you must type “FILED PURSUANT TO REV. PROC. 2013-30” on the top of the Form 2553 and “INCLUDES LATE ELECTION(S) FILED PURSUANT TO REV. PROC. 2013-30” on the top of the Form 1120-S.
Businesses an S-corp Is Best For
Generally speaking, smaller businesses earning net income in addition to the owner’s pay may benefit from electing the S-corp tax designation. The best businesses to form S-corps are those where a portion of the business income can be attributed to something other than the shareholders’ services. This is because if all the income is due to shareholder services, it must all be paid as wages and there is little tax benefit to being an S-corp.
Here are a few scenarios where the S-corp tax status could be advantageous:
- Retail business owner: A store owner, such as that of a hair salon or boutique, who is earning more profit than a reasonable salary as a store manager
- Seasoned professional-based business: A doctor, attorney, or accountant firm earning profits from the work of employees
- Businesses with extensive buildings or equipment: Any business that is heavily invested in buildings or equipment can attribute a portion of their income to those assets
S-corp Pros & Cons
| PROS | CONS |
|---|---|
| Profits, losses, deductions, and credits pass to their shareholders' tax returns, rather than being taxed at the corporate level | Must fill out Form 1120-S and send shareholders a Schedule K-1 each year |
| Offer limited liability protection, shareholders are generally not personally responsible for the company's debts and liabilities | Must withhold and pay payroll taxes on wages to shareholders and file payroll tax returns |
| Income not paid to the shareholder as wages is not subject to self-employment tax | IRS may check to see how “reasonable” your salary is; if it deems it lower than the market rate, then you may owe more in taxes |
| Can be converted back to a C-corp or an LLC | May be more difficult to raise equity capital than with C-corps given the limit on the number and types of shareholders |
S-corp Alternatives
1. LLC: You will want to stay as an LLC and not elect S-corp status if your business won’t earn more net profit than a reasonable salary for your position. A simple LLC will save you time by requiring less documentation than an S-corp.
2. C corporation (C-corp): A corporation that doesn’t elect to be an S-corp is designated a C-corp. Most companies would rather not be a C-corp because they have to pay a 21% corporate tax. However, in certain situations, the business must be a C-corp, such as if it has over 100 shareholders, has a foreign shareholder, or is trying to attract venture capital.
3. Sole proprietorship: Typically, you will only want to be a sole proprietor if your business has a low risk of litigation from clients or suppliers. Many low-risk businesses save money by skipping the legal step of registering a business as a legal entity. However, registering your business as an LLC or corporation would protect your personal assets if a lawsuit were ever filed against the company.
Our comparison of LLC vs S-corp vs C-corp shows how each stacks up against one another and will guide you on how to choose among them for tax purposes. Each structure has its pros and cons, and in some circumstances, you must be a C-corp—such as when there is a foreign shareholder.
Frequently Asked Questions (FAQs)
No, you do not need to file IRS Form 2553 annually. Form 2553 is used to elect S-corp status for a corporation or LLC and must be filed within 75 days of the start of the tax year or at any time during the preceding tax year. Once the election is made, it remains in effect until it is terminated or revoked. However, you’ll need to file Form 1120-S annually.
No, there can only be one type of stock in an S-corp. This means that everyone who owns a company’s stock must have the same rights and benefits.
Yes, you can. When filing Form 2553 for a late S-corp election, you must enter, “FILED PURSUANT TO REV. PROC. 2013-30” in the top margin of the first page of Form 2553. However, you make the late election by attaching Form 2553 to Form 1120-S, and you must enter in the top margin of the first page of Form 1120-S, “INCLUDES LATE ELECTION(S) FILED PURSUANT TO REV. PROC. 2013-30.”
Bottom Line
For most business owners, the choice to become an S-corp is straightforward. If you’re earning more net income than a “reasonable” salary for your position, you could save money in taxes by electing S-corp status. If you’re creating a complicated business structure with multiple shareholders, consider working with a local business attorney to assist with your situation.
