S Corporation FAQ: Frequently Asked Questions about the S Corporation
Question: What, exactly, is an S corporation?
S Corporation -- An S Corporation is a corporation, partnership or limited liability company that’s made an S election with the IRS.
And, yes, you just did read right. An S Corporation doesn't have to actually be a corporation. It needs only to be what the Internal Revenue Service considers an eligible entity.
The S election tells the IRS that the business wants to be treated under the rules of Subchapter S of the Internal Revenue Code.
While there are many complicated provisions in Subchapter S, the basic feature of an S Corporation is easy to understand: S Corporation taxable income or S Corporation tax deductible loss gets allocated to the S Corporation owners based on their ownership percentages.
A S Corporation that makes, say, $100,000 in profits pays no income taxes on that profit. Instead the shareholders of the S Corporation include the profit on their returns.
If two shareholders equally own an S Corporation that makes $100,000, for example, each shareholder adds $50,000 of income to his or her return and then pays the tax on that $50,000 profit from the S Corporation.
Question: In a nutshell, why do people choose S corporation?
Here's the straight-talk answer to this question: Small business owners use S corporations to minimize the amounts they pay in payroll taxes.
Question: A S Corporation seems too good to be true… is there a catch?
Well, yes and no. The catch with an S corporation is that the salary you set for a shareholder-employer such as the owner needs to be reasonable. A low salary might save payroll taxes temporarily, but the IRS should be able to successfully challenge such a salary. The 1120S tax return, which is what an S corporation files, makes it very easy to see when shareholder-employees are under-compensating themselves.
Question: Can sole proprietors become s corporations?
People commonly search web sites like this one for comparative information about s corporations and the self-employed. So let me make just a couple of quick comments: First, a sole proprietor can become an s corporation. And, in fact, most of the do-it-yourself kits I sell here seem to be purchased by self-employed individuals converting their sole proprietorships to subchapter s corporations.
Another quick comment: If you're interested in comparing the features of sole proprietors and subchapter s corporations--in other words, if you're looking for s-corp vs. sole proprietor information--look at the articles available at this web site that discuss the advantages and disadvantages of s corporations. They provide comparisons of the s corporation and sole proprietor forms.
Question: How do you set up an S Corporation?
By correctly filing a timely 2553 form with the IRS service center that will process the S corporation tax return. You typically want to either pay a professional to do this or carefully, carefully read the instructions that accompany the 2553. Note, too, that some states require state-level s elections to be made. If you want some help with the 2553 or with the state-level election, consider purchasing the do-it-yourself kit for your state.
A word about timing of the S election. An S election generally needs to be made by March 15 in order to be effective for that year. For example, in general, for your business to be taxed as an S corporation for 2006, you need to make the S election by March 15, 2006.
Question: What if I missed the S election deadline--am I too late?
It depends. You often can make a late election if you've got a decent excuse. Something along the lines of "I understood my attorney or accountant was taking care of this, but he dropped the ball…" seems to work pretty well.
You need to follow the correct, current IRS procedure for making a late election, however. The correct, correct procedure is described (as of May 8, 2008) in Revenue Procedure 2007-62, "Simplified method for taxpayers to request relief for late S corporation elections."
One other note, however. You must have an eligible entity in place for making the election. In other words, you might be able to get the IRS to grant you a late S election that goes back six or twelve months. But the corporation or limited liability company needs to have existed six or twelve months ago. In other words, the thing you want to treat as an S corporation needs to have existed on the effective date of the S election.
Question: What's a better platform for an S corporation: A regular corporation or a limited liability company?
I like using a limited liability company as the platform for an S corporation rather than a regular, old-style corporation for two reasons:
1. With a limited liability company, you have a simpler set of governance procedures. In a nutshell, you just need to honor the LLC operating agreement. With a corporation, you'll need to get pretty formal and have annual shareholder meetings, a board of directors, regular board meetings, corporate officers, and so forth.
2. You aren't forced to use S corporation tax accounting rules until the S corporation option will save you taxes. In other words, with a limited liability company as the legal entity, you can let the LLC be treated as a sole proprietorship or partnership in the first months or first years of operation. (As noted elsewhere on this web site, an LLC can be treated for tax purposes as just about anything you want.) Treating your LLC as a sole proprietorship or partnership may keep your accounting easier. And such LLC treatment may cause deductions to more easily flow out of the entity and onto your personal return.
One other comment about this LLC versus regular corporation question: Sometimes, in spite of the simplicity and flexibility offered by limited liability companies, people need to go with a regular corporation. For example, investors may be uncomfortable investing in a limited liability company (perhaps because they don't understand the LLC option). And here's another example: customers, vendors and employers may be more comfortable dealing with a regular corporation (again perhaps because they just don't understand the LLC option). In these sorts of cases, you may be forced to use a regular corporation. And that's not that big a deal.
Question: Can any business set up as a S Corporation?
No, there are some restrictions. For example, insurance companies can’t become S corporations. Also, if a business is owned by another business, an S corporation often can't be set up. (As noted elsewhere on this web site, basically only individuals can own S corporations. So if a business is owned by a partnership or a regular non-S corporation (which is called a C corporation), the business can't set up as an S corporation. S corporation shareholders are also limited to 100 shareholders or less--although this rule is relaxed somewhat in the case of families.
Question: Can professionals (doctors, lawyers, and such) use a S Corporation?
Yes. Note that the Wall Street Journal reported in the last presidential election that Democratic candidate John Edwards saved roughly $750,000 in payroll taxes one year by practicing law as an S corporation. He split his over $26,500,000 of law firm profits into roughly $400,000 of salary and a leftover distributive share of $26,000,000.
Question: Does a S Corporation complicate your accounting?
Well, not really. An S Corporation tax return often does need to include balance sheets, however. So that means you need to be using double-entry bookkeeping. Something like QuickBooks or Peachtree or Microsoft Small Business Accounting works fine.
Question: Can you terminate the S Corporation status?
Yes, you can. You terminate an the "S" status of a S Corporation intentionally by asking the IRS to revoke the S election. (This is how you convert a s corporation to a c corporation, if that's what you've decided to do.) And you can unintentionally or inadvertently terminate the S election by doing something that an S Corporation is prohibited from doing.
I've mentioned elsewhere on this web page that basically only individuals can own shares in an S Corporation. If an S Corporation shareholder sells shares to a partnership or C corporation, that new ineligible shareholder may terminate the S election. (A common way this might happen is if an s corporation raises money from a venture capital fund, which would almost always be a partnership: At the point the s corporation issues the stock to the venture capital fund partnership, its subchapter s status terminates and the corporation converts from s status to c status.)
A couple of follow-up points should be made about intentional and unintentional S status terminations. First, if an S Corporation inadvertently goofs up its S status eligibility, prompt correction of the ineligibility and (if necessary) a little pleading with the IRS will often fix the problem. Second, if an S Corporation has multiple shareholders, the S Corporation should have a shareholder agreement that prohibits shareholders from doing things that terminate the Subchapter S status.
A related point: People commonly ask about conversions from s corp to a c corp status, but going from an s corporation to a c corporation is probably something you should do only after consulting with a knowledgable tax practitioner. You typically would not want to make a s to c corporation change or conversion unless you were forced to.
Question: Who can be a S Corporation shareholder?
I've danced around this topic a few places on this web site because it becomes pretty complicated. But here's a bit more detail on who can and can't be an S Corporation shareholder...
Eligible S Corporation Shareholders
U.S. taxpayers and permanent residents, qualified subchapter S trusts, some voting trusts, testamentary trusts created by a will, grantor trusts, revocable trusts created as part of an estate, and certain exempt organizations.
Ineligible S Corporation Shareholders
Nonresident aliens, C corporations, partnerships, and foreign trusts.
Question: Do you need an attorney's or accountant's help to set up an S Corporation?
If you're setting up a Subchapter S Corporation purely for tax reasons, I think you can do the setup yourself. Alternatively, you can use one of the many paralegal services available over the web.
If you're setting up the corporation or LLC (you can also use an LLC as an S Corporation), I observe that entrepreneurs and investors often feel like they get excellent value from spending the extra money on a good attorney who not only steps you through the process but also explains the liability protection.
Question: How do states treat S corporations?
Great question. Unfortunately, the answer is a little complicated.
Perhaps the first thing to know, however, is that generally states treat S corporations the same way that the federal government treats S corporations. For example, if you make a valid S election with the IRS for federal income tax purposes, most often your state also honors that federal S election for state purposes. As another example, in general, S corporation shareholders are subject to state income taxes on their proportional shares of the S corporation's profit--just as they're subject to federal income taxes on their proportional shares of the S corporation's profit.
Numerous little exceptions to these general rules exist, however:
1. Some states do not recognize S corporations--in other words, they treat S Corporations like C corporations. At the time of this writing, the District of Columbia, New Hampshire, and Tennessee fall into this category. Note that you can still have an S corporation in these states--and that can still mean big federal tax savings--but the S corporation will only be an S corporation for federal tax purposes and not for state tax purposes. For state purposes, the corporation will be treated as a regular C corporation.
2. Some states tax S corporations on part of their income even though they do recognize the S corporation. For example, Massachusetts taxes S corporations on their profits when the profits rise about a specified limit. (Note: Shareholders in Massachusetts S corporations are not taxed on their shares of this "taxed" S corporation income.) And several other states tax shareholders on the S corporation's income and also tax the S corporation on some of its income. For example, in both Indiana and Kentucky, while shareholders get taxed on their proportional shares of the S corporation's profits (meaning the state has taxed all of the business's income), the S corporation also pays taxes again on capital gains and on excess passive income. Idaho, Maine and Wisconsin play a similar game with S corporations.
3. A small handful of states, including Michigan, California, New Jersey and New York, tax both the S corporation's profit... and the shareholder's proportional shares of the S corporation's profits. This means that in a sense the S corporation is double-taxed in a manner similar to a C corporation that distributes all of its profits as dividends.
Michigan, for example, taxes the S corporation shareholder on all of his or her income because Michigan does recognize the federal S corporation election for purposes of passing through S corporation profits to shareholders. Michigan also taxes the corporation on that same income via its single business tax. Fortunately, most small businesses--the sorts that would elect S corporation status--either aren't subject to the single business tax or don't pay very much single business tax. (At the time I'm writing this, a business is exempt from the single business tax if its gross receipts are less than $350,000.Michigan may just win the dubious honor of being the worst state in the nation to setup an S corporation.)
California, New York and New Jersey also tax both the corporation and the shareholder on business profits. Fortunately, in these three states, the state corporate tax rate levied on the S corporation's profits is modest. In California, for example, the S corporation tax is often a flat $800 a year.
4. In general, if an S corporation does business in another state (other than the home resident state), that other state will want to tax all shareholders--even nonresident shareholders--on their proportional shares of the S corporation's income earned in that other state. Some states as a convenience let the S corporation pay the income taxes owed by shareholders or nonresident shareholders.
As a final general comment about the state taxation of S corporations, let me suggest that if you want to turn an LLC into an S corporation or if you want to set up a new S corporation, it's a good idea to call the state income tax agency where the S corporation will operate and ask two questions: One, whether there's a separate state S corporation election form that needs to be filled out... and, two, if they have any information they can provide to you concerning the taxation of S corporations. You obviously don't want to be surprised.