Qualifications, Process, and Benefits
By Jean Murray
After you have formed your corporation, you can decide to become a Subchapter S Corporation (S corporation). Here is information on this type of corporation and how to complete a Sub-chapter S Election Form.
Subchapter S Corporations
An S corporation is a corporation that elects "small business" status, under Subchapter S of the Internal Revenue Code. S corp status allows the corporation the limited liability benefits of a corporation, but the tax rate of the individual shareholders. (1)
Corporate Shareholders vs. S Corporation Shareholders
The owners of corporations and S corporations are called shareholders.
Shareholders of corporations receive dividends as approved by the corporate board of directors.
S corporation shareholders report their share of income or loss on their personal tax returns. The shareholders are then taxed on this income, along with their other income, at their personal tax rate.
Qualifications to Elect S Corporation Status
The IRS qualifications for S Corporation status are:
It must be a domestic (U.S.) corporation, with no foreign investors;
It must have no more than 100 shareholders;
It has only one class of stock;
It must use a December 31 year-end.
Shareholders may be individuals, certain kinds of trusts, and estates, but partnerships, corporations, or non-resident aliens may not be S corporation shareholders. (2)
Filing an S Corporation Election
An S corporation isn't a separate business entity; it's a form of corporate taxation. Here's how it works:
A corporation is set up and doing business.
At some point, the corporation decides to be taxed as an S corporation. This is called an "election."
The process for electing S corporation status begins with an IRS application, on IRS Form 2553. Form 2553- Election by a Small Business Corporation. This form gives the IRS detailed information about the corporation requesting S Corp status and about the corporation's eligibility for electing this status.
You will need the following information to file Form 2553: (3)
The name and address of your corporation
The employer ID (EIN) of the corporation
The date and state of incorporation
If the corporation has changed its name or address after applying for S corporation status
The tax year for which the election is to be effective. (You have several options for selecting a tax year.)
If you have more than 100 shareholders but you are treating members of a family as one shareholder to keep the number under 100, there is a box to check.
Name, address, and phone number of a corporate officer or legal representative who can be contacted for more information.
If you are filing the election late, you have the opportunity to claim that you had "reasonable cause" for filing late.
The final section asks you to list all the shareholders who must consent to the election, with the number or percent of shares owned, date acquired, and tax year of each shareholder. Each shareholder must also sign and date the form.
Part II includes questions about the corporation's tax year.
Part III relates to Qualified S Trust Elections.
Part IV relates to Late Corporate Classification Election Representations.
The IRS requires that the Sub-chapter S Election be filed
No more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or
At any time during more than two months and 15 days after the beginning of the tax year that the election is to take effect. (3)
If your business starts on January 7, you must file the election no later than March 15. Failing to file means you will not receive Sub-chapter S status for that tax year.
Benefits of Electing S Corp Status
The benefits of electing S corporation status for your corporation include:
An S Corp has the same liability protection as a corporation. Because an S Corp is a corporation, it retains the separate entity protection of a corporation, and the corporate shield of protection against liabilities protects the owners from lawsuits or responsibility for debts of the corporation, in many cases.
S Corp status can reduce self-employment taxes. Owners of sole proprietorships and partners in partnerships must pay self-employment tax (Social Security and Medicare tax) on total profits. But S corp shareholders are not considered to be self-employed and they don't pay self-employment taxes.
S Corp status can avoid double taxation As mentioned above an S corp has an advantage over a corporation because the S corporation does not have double taxation. A corporation pays corporate income tax on its profits, then the owners are taxed on the dividends they receive (from the profits), resulting in double taxation. In an S corp, on the other hand, the corporation doesn't pay income tax; the owners pay income taxes based on their respective shares of the profits.
S corp losses can reduce owner taxes. If the S corp has a loss, each owner's share of that loss is passed through to the individual income tax return. If the owner has other income, the loss can reduce all or part of that income. There are limits to owner losses, depending on the owner's participation in the business.
S corp profits are taxed at individual rates. Because S corp profits are taxed to the owners personally, the taxes may be less than the corporate tax rate of 21%), so the tax may be lower, depending on the individual owner's tax rate.
Disclaimer: Like many other matters relating to the IRS, this election is complicated, and every business situation is different. In order to make certain that the election is filed properly and on time, hire a qualified business firm to do this paperwork.
Jean Murray, MBA, Ph.D., is an experienced business writer and teacher. She has taught at business and professional schools for over 35 years and has written on U.S. business law and taxes since 2008.