S corp taxes: Eligibility, filing, converting

An S corporation (S corp) is a US tax code for small businesses. If you see “Inc.” after a company’s name, it is incorporated - meaning it is designated as a separate entity from its owners.

One of the key reasons businesses assume S corp status is for its various tax advantages. However, the IRS rules governing S corps can be complex.

Here, we will distill the finer points of S corps and their tax treatment for small business owners to make an informed choice for their business structure.

What is an S corporation?

An S corporation is a legal business entity designed to pass corporate income, losses, deductions, and credits to its shareholders for federal tax purposes. It combines the characteristics of a corporation and a partnership, specifically for tax purposes.

It’s a popular choice among small business owners seeking the benefits of a corporate structure, aiming to maximize their business income by eliminating the burden of double taxation.

The S corp designation

The S corp designation is more than just a title – it’s a strategic decision that can significantly impact a business’s tax landscape. S corporations are not distinct legal bodies. Rather, they are entities with a specific tax status under the United States tax code that eligible corporations or LLCs can elect.

Electing S corp status enables a business to modify its tax structure, shifting taxation from the corporate to the shareholder level. This means that an S corp’s income, losses, deductions, and credits pass through to the individual shareholders’ tax returns based on their share of ownership.

Eligibility criteria for S Corp status

Despite the numerous benefits of S corp status, not all businesses are eligible. For a corporation to secure S corporation status, certain conditions must be fulfilled:

• It must be a domestic entity with 100 or less shareholders
• It must maintain a single class of stock
• All shareholders must agree to the election
• Shareholders must be individuals, certain trusts, or estates
• All shareholders must be US citizens or permanent residents

Additionally, certain businesses such as financial institutions, insurance companies, and domestic international sales corporations are specifically excluded from electing S corporation status.

S Corp taxation

A closer look at the tax mechanics of S corporations reveals an intricately designed system aimed at reducing tax burdens.

Distribution of corporate income

The distribution of corporate income is a key element of the S corp taxation mechanism. 

S corp income, losses, deductions, and credits are passed through directly to shareholders to avoid double taxation. 

Shareholders include their allocated share of the corporation’s income or losses on their personal tax returns using Form 1040, taxed at their individual income tax rates.

Income for the tax year is allocated to shareholders on a per share, per day basis, ensuring that income is divided fairly among shareholders who were owners during that year.

Handling of net income and losses

Shareholders of S corporations report income and losses on their personal tax returns and are taxed at individual rates, which can impact personal tax liabilities. 

However, shareholders cannot deduct S corporation losses in excess of their stock and debt basis; such losses are suspended and carried forward indefinitely.

Specific rules also limit the deduction of losses from passive activities and overall net business loss.

Annual filing and compliance requirements for S corps

Maintaining their unique tax status requires S corporations to prioritize compliance and fulfill several requirements.

Annual filing obligations

S corporations are required to file an annual tax return using Form 1120-S to report their income, deductions, and payments. Shareholders’ profits, losses, and deductions are documented in Schedule K-1, which is attached to and filed with Form 1120S.

The income tax return documents, both Form 1120S and the accompanying K-1s, are due to the IRS by the 15th day of the third month following the close of the tax year, usually March 15.

Reasonable compensation rules

The IRS also sets rules on reasonable compensation for S corporation shareholders. S corporation shareholders must receive reasonable compensation for their services before taking non-wage distributions, which impacts their self-employment tax liabilities.

The IRS defines reasonable compensation for an S Corp shareholder as what similar businesses would pay for comparable services, considering factors such as training, experience, and duties.

Failure to comply with these rules, as outlined in the Internal Revenue Code, can result in the IRS reclassifying distributions as salaries, leading to employment taxes, penalties, and interest.

Tax advantages of S corps

An S Corp owner can pay themselves a smaller salary aligned with the profitability of the business, their part-time involvement, or the non-exclusive reliance on their efforts, providing a flexible approach to how much they are taxed for self-employment. Company profits must typically exceed a reasonable salary that an owner would earn to realize these tax savings.

The “60/40 rule” serves as a straightforward method for S corp owners to define an appropriate salary for themselves. This formula splits owners’ business income in two: 60% as salary and 40% as shareholder distributions.

Avoiding double taxation

S corporations have a unique tax structure that allows them to avoid double taxation, which differs significantly from C corporations that face corporate income tax followed by additional taxation on dividends.

Unlike C corporations, S corporations have the following advantages:

• Exempt from federal income tax at the entity level
• Benefit from pass-through taxation, similar to partnerships

However, there are specified exceptions to the pass-through taxation advantage of S corporations, such as tax due on certain passive income and built-in gains at the corporate level.

Self-employment tax considerations

An S Corporation’s structure allows for reducing self-employment taxes by mandating self-employment tax payment solely on the owner’s salary, not on the entire company’s profit distribution. Reasonable compensation for S corporation shareholders is critical to avoid IRS scrutiny and potential reclassification of distributions as wages, which are then subject to payroll tax.

S corporation shareholders can also benefit from tax deductions through health and accident insurance premiums if they own more than 2% of the shares and home office expenses through the businesses’ accountable plan.

State-level S corp taxes

Some states align with federal treatment of S corporations as pass-through entities, while others levy extra taxes. State tax implications for S corporations vary based on each jurisdiction’s laws and regulations.

For instance, California requires S corporations to pay an $800 minimum tax or a 1.5% franchise tax on income, while Alabama has a business privilege tax based on an entity’s taxable net worth.

Massachusetts imposes an extra tax on S corporation profits once the company reaches a specified size.

Familiarity with specific state tax laws is crucial for S corporations to ensure compliance and prevent unforeseen tax liabilities.

Multi-state S corp taxation

The tax landscape can become even more complex for S corporations operating in multiple states. Many states require nonresident shareholders of S corporations to file composite tax returns or impose tax withholding obligations to ensure compliance.

While composite returns allow S corporations to file on behalf of nonresident shareholders, some states, such as Nebraska and Tennessee, do not accept composite filings. States may also require S corporations to withhold taxes for nonresident shareholders, which are credited on the individual’s nonresident tax returns.

Strategies for managing S corporation taxes

Despite the complexity of the tax landscape for S corporations, effective tax management can be achieved through several strategies.

Tax planning and estimated payments

S corporations can avoid hefty penalties through effective tax planning and timely estimated payments. 

To pay federal income tax, S corporations must make quarterly estimated income tax payments based on the corporation’s projected annual taxable income, with deadlines typically falling on the 15th day of the 4th, 6th, 9th, and 12th months of the tax year.

Ensuring timely payment of estimated taxes is crucial for S corporations to avoid underpayment penalties, and maintaining a schedule of even payments throughout the year can help manage cash flow and minimize the risk of penalties.

Maximizing deductible business expenses

Claiming deductible business expenses is another effective strategy for managing S corporation taxes. S corporation shareholders can deduct legitimate business expenses to lower their overall taxable income. These deductible business expenses can include:

• Everyday operational expenses
• Insurance premiums
• Lease payments for business equipment
• Interest on business loans
• Vehicle expenses for business purposes
• Business communication expenses
• Expenses for educational purposes related to the business

Transitioning to S corporation status

For businesses seeking tax benefits, transitioning to an S corporation from a different business structure can be a strategic decision. To receive S corporation tax treatment, a corporation must:

1. File Form 2553 with the IRS
2. Have the election signed by all shareholders
3. Make the S corp election during the corporation’s tax year and on or before the 15th day of the third month

If the election is missed, it will be delayed until the next tax year.

From LLC to S corp

LLCs considering a transition to S corporation status need to be aware of the specific steps involved. An LLC that wishes to elect S corporation status must file Form 2553, ‘Election by a Small Business Corporation,’ signed by all its shareholders as per IRS instructions.

The conversion from LLC to S corp typically requires a statutory conversion, which is processed through the state filing office and must include member approval and compliance with state-specific requirements.

From C corp to S corp

Although C corporations can convert to S corporations, they must be aware of potential tax implications. Converting from a C corporation to an S corporation requires filing IRS Form 2553. 

However, when a C corporation converts to an S corporation, it may be subject to built-in gains tax on appreciated property recognized within 5 years after the S election takes effect.

Unused net operating losses from when the entity was a C corporation cannot offset income earned as an S corporation and cannot be passed through to shareholders.

Final word

Electing S corporation status can offer businesses a number of tax benefits, from avoiding double taxation to reducing self-employment taxes. It’s crucial, however, to understand the specific tax mechanics, compliance requirements, and potential state-level tax implications associated with this business structure. With careful planning and strategic decision-making, S corporations can maximize their tax advantages and pave the way for financial success.

Frequently Asked Questions

How much tax will I pay on S corp?

The S-Corp election allows you to split profits into “shareholder wages,” subject to 15.3% self-employment taxes, and “distributive share,” not subject to 15.3% self-employment taxes. Active owners must pay themselves a reasonable salary but realize a 15.3% savings on retained profits. S corps don’t pay federal corporate income taxes; individual shareholders report income or losses on their personal tax returns.

Does an S corp pay taxes on revenue or profit?

An S corporation doesn’t pay federal income tax on its business income. Instead, the business income, deductions, losses, and other tax items flow through to the business owners. This means that taxes are not paid at the corporate level, similar to a partnership.

Does an S corp really save taxes?

Yes, operating as an S corporation can help reduce self-employment taxes for owners, as they can receive money as dividends without employment tax. Still, additional legal, accounting, and state fees might offset these savings.

Is an S corp taxed at 21%?

No, an S Corp is not taxed at 21%. Income is passed through to shareholders, who pay tax on their individual returns. C Corporations have a flat tax rate of 21%.

What is an S corporation?

An S corporation is a legal business entity that passes income, losses, and deductions through its shareholders for federal tax purposes.