We mentioned in a previous article about the benefits of having your business taxed as an S-Corporation. If you read that article and want to save on self-employment taxes you first have to have a clear understanding of what the S-corporation is and how to go about forming one for your business.
If you are a corporation the IRS will consider you, by default, a C corporation. That is an important factor because a C corporation is a separate entity and files its own tax return. Equally if not more important is the fact that the owners, or shareholders, in a C corporation are taxed twice. First the owners are taxed at the corporate level and then again when the profit of the business id distributed as dividends. To make matters worse the shareholders do not get to deduct any losses that the C corporation has.
How to Make My Business an S-Corp
So what can be done to avoid this double taxation effect of the C corporation? Elect to become an S-corporation! The IRS allows C corporation shareholders, or LLC’s, to elect to be taxed as an S-corporation by filing Form 2553. The benefit of this is that, after the election is made, the profits of the corporation will flow through to the shareholders’ tax return where if any tax is due it is paid once thus avoiding the double taxation. Additionally, if the S-corporation suffers any losses the shareholders are allowed to take those losses on their individual tax returns.
Form 2553 must be made within 2.5 months after the beginning of its tax year for the election to be effective for the beginning of the year. However, if you are reading this and more than 2.5 months have passed, there is an exception that may still allow you to take advantage of the S corporation election. Speak with your accountant on how this can be done or you can contact our office and we can help you.
You will need all the shareholders to sign Form 2553 and the corporation must have its own tax identification number.
New Entity, New Rules
Like most things in life there are pros and cons. The S corporation is no different. The following are requirements for your S corporation to be valid:
- Cannot have more than 100 shareholders
- Shareholders must be U.S. citizens or residents or certain trusts or tax-exempt corporations
- Shareholders cannot be a corporation or partnership
- Must be a domestic corporation
- Must have only one class of stock
- Profit and losses must be allocated in proportion to the shareholder’s ownership
What Happens Next
An S corporation is not a sure thing. The IRS has to make a determination on your request. It can, for a number of reasons, deny your request. If it accepts your request (HOORAY you’re on your way to big tax savings!) the IRS will send you a confirmation letter by mail.
If you live in a state with state income tax you may have to file a separate election so that the same pass-through treatment is granted.
An S corp election can be a great way for you to keep more money in your pocket so long as you know both the benefits and limitations.