Small business owners know all too well the value of every penny and that they must constantly look for ways to maximize profit to ensure growth and sustainability. That’s why many small business owners opt for an S corporation election with the IRS.
S corporation = big savings potential
S corporations and limited liability companies (LLC) are created under state law and enjoy the benefits of pass-through taxation by electing to be taxed under Subchapter S of the Internal Revenue Code. The tax savings can be huge for small businesses, saving these entities up to 7.5 percent on employment tax.
The election to become an S corporation is done by filing an S Election (Form 2553) with the IRS within 75 days of formation; though if you miss that deadline you may still be eligible for late-filing relief for the S election.
In a nutshell, an S corporation pays no income tax, instead the business’ income is passed through its shareholders, who report it on their individual tax returns and are, therefore, taxed at the personal income rate.
In an S corporation, the owners/shareholders can be employees of the business and receive a salary that is subject to the same payroll taxes as any other employee’s salary and, in fact, any shareholder who works for the company must take a salary.
Is it right for your business?
The IRS requires a business to meet the following criteria to qualify for S corporation status (source: https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations):
- Be a domestic corporation.
- Have only allowable shareholders.
o May be individuals, certain trusts and estates, and
o May not be partnerships, 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).
Additional factors to consider:
- Once you make an S corporation election, you must stick with that status for five years, so you’ll want to feel comfortable with keeping your business small (and have no plans to go public) for the near future.
- All profits and losses for an S corporation pass through strictly based on a shareholder’s percentage of stock ownership. This means that if you and your co-owner each own 50 percent of the business. So be aware that if say, in one year you do 70 percent of the work and your co-owner only does 30 percent of the work, the profit still must be split 50/50; it cannot be split 70/30.
- If you intend to raise venture capital (VC) in the future, know that most VC firms prefer to invest in C corporations and it’s usually easier to convert an S corporation to a C corporation than it is to convert an LLC to a C corporation when the time comes to do so.
The tax attorneys at Robinson & Henry are here to help with all your tax planning needs, and can help determine if an S corporation election is right for your business. We routinely handle S corporation conversions that result in significant tax savings for those business owners. Contact us at 303-688-0944 to schedule an assessment.