When should I file as an S Corporation?

‍Key Takeaways

• S Corp is a designation, not an entity type
• You can elect for your business to be treated as an S corp using Form 2553
• S corp elections are due within two months and 15 days after the first day of the tax year
• S corp owners are required to pay themselves a reasonable salary
• At $50,000 of net business profit, it may be beneficial to start filing as an S corp
• Stay compliant, or you can lose the S corp election status

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S corporations receive a lot of attention from small business owners as a way to potentially limit personal liability and save on taxes. However, this election will not be the right choice for every business. If you are considering whether it may be worth making this election, you should know what it involves and how it can affect your taxes. 

What is an S Corporation?

An S corporation, or Subchapter S corporation as it is formally known, is a tax designation granted by the IRS. S corps are known as flow-through entities because all business income, credits, and deductions flow through to the shareholders who will receive a K-1 reporting this information. Any tax is then assessed on the shareholder’s personal tax return at their individual income tax rate. This enables S corps to escape double taxation on corporate income. 

Requirements for Filing as an S Corp

In order to qualify for S corp status, a business has to meet specific requirements set by the IRS. The S corp must: 

• Be a domestic corporation
• Have only allowable shareholders
• These can be individuals as well as certain trusts and estates
• Partnerships, corporations, and non-resident aliens cannot be shareholders
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation which, according to the IRS, includes insurance companies, certain financial institutions, and international sales corporations

If the business ceases to meet the requirements, S corp status will automatically be terminated. This termination is effective as of the date that the disqualifying event occurs. 

How are S Corp Elections Made?

As long as your business meets the conditions listed above, you are able to file an election for S corp status. This is done by completing Form 2553 Election by a Small Business Corporation which can then be submitted to the IRS by mail or fax. Some of the information required for the form includes:

• Business name, EIN, and address
• Date of incorporation and state of incorporation
• Effective date of the election
• The business’s tax year

You must also include the names, addresses, and social security numbers of all shareholders. The number of shares or percentage of ownership will need to be listed for each shareholder as well as the dates acquired. Finally, all shareholders have to consent to the election by signing and dating the form in Column K. After S corp status is granted, all business activity will be reported annually on Form 1120S. 

S corp status can also be voluntarily revoked with sufficient shareholder consent. Keep in mind that if you ever decide to revoke your S corp status, you cannot make the election again for at least five years without IRS consent. 

When are S Corp Elections Due?

If you would like to file for S corp status, you must do so within two months and 15 days after the first day of the tax year. This gives you roughly 75 days in total to make the election. For example, say you launched your business on February 8, 2024. You would have two months and 15 days from the date of formation or incorporation to file a timely S Corp election. 

Missing the deadline does not necessarily mean you cannot become an S corp for the desired year. However, you must show that your business intended to be classified as an S corp, is eligible, and would otherwise qualify to be an S corp if the election were made on time. 

There also needs to be reasonable cause for not filing Form 2553 by the due date. The IRS is often fairly lenient on what constitutes reasonable cause. If your business has been operating as though it were an S Corp, but you or your accountant forgot to file Form 2553, the election will likely be approved. There is space on Form 2553 to provide an explanation for late filing, and a longer statement can be attached. You should receive official confirmation from the IRS when your election is accepted. 

How are S Corp Owners Paid?

S corp owners who are also employees are required to pay themselves a reasonable salary before taking any tax-free distributions. For this reason, you should determine whether your business can afford to pay you a reasonable salary before electing S corp status. 

Although there are no specific guidelines for determining a reasonable salary, the IRS takes several factors into account such as:

• Training
• Experience
• Responsibilities
• Time devoted to the business
• Dividend history

 It is also helpful to find out what comparable businesses are paying for similar services.

When Does an S Corp Election Make Sense?

There is no one-size-fits-all answer to this question. Before making an S corp election, you should consider your tax situation as a whole as well as your expectations for the future. A common threshold for making an S corp election is when you reach at least $50,000 of net business profit. The tax savings at this point can outweigh the compliance costs which include, among others, an additional tax return and payroll processing costs. 

The savings can be especially great if your business profit is currently subject to self-employment taxes (Social Security and Medicare) of 15.3%. S corps do not pay Social Security and Medicare taxes on the entire business profit. Instead, these taxes are only paid on wages. 

You may not want to become an S corp if you do not plan to be in business long-term or if you have W2 income that is close to or above the Social Security limit. It is best to talk with an accountant if you are not sure whether S corp status is right for your business. 

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How to stay compliant with the election of S corp status

If you decide to move forward with S Corp status, it is important to remain compliant. Here are some tips on doing so.

• Maintaining Corporate Formalities: Ensure that corporate formalities such as regular board meetings and keeping accurate records of company decisions are maintained.
• Filing Annual Reports: File annual reports with the state where the S corp is registered, including any necessary fees.
• Submitting Tax Returns: File an annual tax return (Form 1120S) with the IRS, as well as any required state tax returns.
• Paying Taxes: Ensure that all applicable federal, state, and local taxes are paid on time, including income taxes and payroll taxes.
• Distributing Profits Correctly: Ensure that profits and losses are distributed correctly among shareholders according to their ownership percentages.
• Keeping Records: Maintain accurate financial records, including income statements, balance sheets, and cash flow statements.
• Complying with Employment Laws: Adhere to all applicable employment laws and regulations, including those related to hiring, wages, and workplace safety.
• Updating Corporate Documents: Keep corporate documents such as bylaws, articles of incorporation, and shareholder agreements up to date.
• Avoiding Prohibited Activities: Avoid engaging in activities that could jeopardize the S corp's status, such as having more than 100 shareholders or having ineligible shareholders (e.g., non-resident aliens, certain types of trusts).
• Seeking Professional Advice: Consult with legal, tax, and financial professionals to ensure ongoing compliance with all applicable laws and regulations.

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