In plain English
Your state creates the company: a corporation or an LLC. The IRS decides how that company is taxed. An S election changes the federal tax treatment, not the legal entity. An LLC that elects S corporation taxation is still an LLC under state law. It files the S corporation tax return, Form 1120-S, and S corporation tax rules apply to it.
With the election, the business generally does not pay federal income tax on its profit. Income, losses, deductions and credits pass through to the shareholders, who report them on their personal returns and pay tax at their individual rates. That is how an S corporation avoids the double taxation a C corporation faces. It can still owe tax at the entity level in certain cases, such as on certain built-in gains and passive income.
Owners who work in the business are shareholder-employees. The IRS says an S corporation must pay them reasonable compensation, as wages, for the services they provide before it makes non-wage distributions to them. Wages mean payroll: withholding, employment tax deposits and payroll returns.
Example
Why it matters
"Make it an S corp" is one of the most repeated pieces of tax advice on the internet. Whether it makes sense depends on the business's profit, what a reasonable wage for the owners' work would be, the cost of payroll and an extra tax return, the owners, and how your state treats the election. It is a decision about the actual business, not a revenue number.
Who can elect it
Under the IRS rules, the business must be a domestic corporation, or a domestic entity eligible to be taxed as a corporation, which includes an LLC. It can have no more than 100 shareholders. Shareholders generally must be individuals, certain trusts and estates, or certain tax-exempt organizations. Partnerships, corporations and nonresident aliens cannot be shareholders. It can have only one class of stock, and certain businesses, such as some banks and insurance companies, are ineligible.
Every shareholder must consent. Form 2553 generally has to be filed no more than 2 months and 15 days after the start of the tax year the election is meant to take effect, or at any time during the year before. The IRS offers relief for late elections in some cases.
Where people get confused
An S corporation is not tax-free. Its income is still taxed. The tax is reported on the owners' personal returns instead of at the corporate level.
States do not all treat S corporations the same way as the federal government. Check your state's revenue agency, or ask your CPA, before assuming the state follows the federal election.
It is not a quick switch to flip back. Once made, the election stays in effect until it is terminated or revoked. After that, the IRS generally must consent before the business can elect S status again before the fifth tax year.
Sources
- IRS. S corporations
- IRS. S corporation compensation and medical insurance issues
- IRS. Instructions for Form 2553
- IRS. LLC filing as a corporation or partnership
- IRS. Business structures
- 26 U.S.C. Subchapter S, section 1361 (S corporation defined)
- U.S. Small Business Administration. Choose a business structure