What Is an S Corp Election?

An S corp election is one of the most talked-about tax moves for small business owners, and one of the most misunderstood. It does not create a new company or replace your LLC. It is a choice you make with the IRS about how your business's income is taxed. For the right business at the right time it can lower taxes. For others, it adds cost and paperwork without much benefit.

What the Election Actually Changes

By default, the IRS taxes a single-member LLC like a sole proprietorship and a multi-member LLC like a partnership. In both cases the profit flows through to the owners' personal returns, and the owners pay income tax plus self-employment tax on their share of the profit. Self-employment tax covers Social Security and Medicare and adds up to 15.3 percent, with the Social Security part stopping at a yearly wage limit.

When an LLC or corporation elects S corporation status, profit still flows through to the owners' personal returns, so the business itself generally does not pay federal income tax. What changes is how owners who work in the business get paid. They become employees of their own company and receive a salary through payroll. Payroll taxes apply to that salary. Profit paid out beyond the salary, called a distribution, is not subject to self-employment or payroll tax. The LLC taxes guide explains the default rules in more detail.

Where the Savings Come From, and the Catch

The potential savings come from the gap between salary and distributions. But the IRS requires owners who work in an S corporation to pay themselves reasonable compensation: roughly what the business would pay someone else to do the same job. You cannot set a tiny salary and take everything else as distributions. If the IRS decides a salary is too low, it can treat distributions as wages and add back the taxes, plus penalties.

The election also brings new costs:

• Running payroll, with withholding, quarterly payroll returns, and W-2s.
• A separate business tax return, Form 1120-S, generally due March 15 for calendar-year businesses.
• More bookkeeping and often higher accounting fees.
• State rules that differ. Some states tax S corporations or charge franchise taxes that affect the math.

Because of this, the election tends to make sense only once profit is steady and high enough that the tax savings clearly outweigh the added costs. LLC vs. S Corp: Which Fits Your First Year? walks through how to think about timing.

A Simple Example

Imagine a one-owner LLC with $100,000 of profit after expenses. Taxed the default way, self-employment tax applies to nearly all of that profit. Now imagine the same business as an S corporation, where a reasonable salary for the owner's role is $60,000. Payroll taxes apply to the $60,000 salary, and the remaining $40,000 can be paid as a distribution without payroll tax. Income tax still applies to all of it either way.

The difference in payroll and self-employment tax is the possible saving. From it, subtract the cost of payroll service, extra tax returns, accounting, and any state taxes. The numbers here are only an illustration. A tax professional can run them with your real figures.

Who Can Elect

Not every business qualifies. To be an S corporation, a business generally must:

• Be a domestic corporation or an LLC that elects to be taxed as one.
• Have no more than 100 shareholders.
• Have only allowable shareholders: generally individuals, certain trusts, and estates. Partnerships, corporations, and nonresident aliens cannot be shareholders.
• Have only one class of stock, which for an LLC generally means owners share in profits and distributions in proportion to ownership.

Owners living outside the United States who are not U.S. residents for tax purposes cannot hold shares in an S corporation. The non-U.S. founders guide covers the options that do fit.

How and When to Elect

The election is made with IRS Form 2553, signed by every owner. An LLC can file Form 2553 directly; it does not need a separate form to be treated as a corporation first. Timing matters:

• To take effect for the current tax year, file no more than 2 months and 15 days after the start of that tax year. For a calendar-year business, that is generally March 15.
• For a new business, the clock starts when the business begins its first tax year, which is often when it is formed or starts operating.
• You can also file any time during the year before the year you want it to start.
• If you miss the deadline, the IRS offers relief for late elections in many cases, if you have a reasonable cause.

Make sure your EIN and business details match your IRS records before you file, and keep the IRS acceptance letter with your records. Our S corporation election service helps you prepare and file Form 2553, and our taxes and accounting service can connect you with tax help to decide whether it fits. Each one is available on its own.

This post is general information, not legal or tax advice. Rules differ by state and change over time, so check your state's official website or a licensed professional before you act. YaH Brands is not a law firm or an accounting firm.

An S corp election is a tool, not a status symbol. Run the numbers with a tax professional before you pick it up.