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Tax Implications of Electing as an S Corp

If you run a small business and use a corporation or limited liability company, you may save more money in income taxes by electing to treat your business entity as an S-corp. There are some disadvantages to making tan S-corp election, but it always depends on the needs of your specific business since once the election is made, the Internal Revenue Service will not allow you to change back to the business’ original tax designation for five years.

How to Make S-Corp Election

In order to make the S-corp election, Form 2553 needs to be prepared and filed with the IRS. When preparing Form 2553, you must disclose whether your business uses a fiscal or calendar year for its books and records, the year in which the election is to be effective, the name of an appointed representative of the company, an employer identification number (EIN) and a number of other questions. Additionally, Form 2553 cannot be filed until all shareholders, or LLC members have given consent to the election by signing the shareholders’ consent statement on the form.

S-Corp Tax Implications

Corporations that don’t make the S–corp. election will be subject to double taxation insofar as the corporation first pays tax on its net earnings, and if a dividend is paid with the after-tax fund, shareholders report the dividend payments on their personal returns and generally pay additional taxes. When the S-corp election is made, however, the corporation’s shareholders can take advantage of pass-through taxation. Pass-through taxation lets shareholders pay all income taxes on corporate earnings (in proportion to their share of ownership). And despite having to file an 1120-S, which is the S-corp tax return, the corporation won’t pay tax; rather, Form 1120S is used for informational purposes.

Self-Employment Tax Savings

Sole proprietors and members of an LLC don’t usually see much income tax savings with an S-corp election since they aren’t subject to the same double taxation that corporations are subject to. However, the election can save you a substantial amount in self-employment taxes – which fund the Social Security and Medicare programs. Generally, sole proprietors, LLC members and partners must pay a percentage of their total net earnings in self-employment taxes. In S-corps, however, shareholders can take a reasonable salary, pay self-employment taxes on that amount and withdraw the remaining profits without having to pay self-employment tax on it. For example, if you have a 50-percent interest in an LLC and your share of net earnings for the year is $100,000 – you will pay self-employment tax on the entire amount. But if the LLC made an S-corp election and $60,000 was an appropriate salary for the services you provide, you can eliminate self-employment taxes on the remaining $40,000.

Other S-Corp Restrictions

One adverse implication of making an S-corp election is the restriction on how many, and the type of shareholders the corporation may have. To ensure that S-corp elections are only used by small businesses, the Internal Revenue Code sets the maximum number of shareholders to 100. When making the election on Form 2553, this limitation may have no impact on your business. But as your business grows you may decide to raise more money by issuing additional shares to investors. If too many new shareholders exist, it’s possible that your company will no longer qualify for the S-corp designation. Moreover, issuing shares to individuals who are nonresident aliens to another business entity will cause your company to lose its S-corp status.

IRS Form 2553