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Have questions about S corporation taxes? You’re in the right place. Whether your company is already taxed as an S corp, or you’re considering the S corp election, in this article I’ll cover the basics of S corp taxation. You’ll leave with a clear direction for next steps in the tax filing process.
What is an S corporation?
An S corporation is a business entity that has elected to be taxed as a “small business corporation” for federal tax purposes. For entities that have made this election, their S corporation tax status is in addition to their legal status.
In the United States, business entities are established in accordance with legal statutes applicable to the state in which the entities are formed. Legal entity types include LLCs, corporations, general partnerships, limited liability partnerships, professional corporations, and others.
The process through which the IRS taxes a business entity depends on the entity’s legal structure. LLCs aren’t taxed in the same way that corporations are taxed. Even some LLCs are taxed differently than other LLCs.
For example, suppose you’re the sole member (i.e. owner) of an LLC that you formed in accordance with the laws of the State of Delaware. The entity’s legal structure is an LLC.
The IRS doesn’t recognize your single-member LLCs as a taxable entity and instead “disregards” the entity. As such you’re required to report the business’ income on your personal income tax return.
However, a business owner has some discretion in determining how their business will be taxed, which opens the door for strategic tax planning.
A single-member LLC, and other legal entities, can elect S corporation status to be taxed as a pass-through entity by the IRS. The entity retains its legal structure for the state in which it was formed, but the IRS will tax the business as a unique tax entity.
An S corporation is a “pass-through tax entity,” meaning that the entity files its own income tax return (Form 1120-S) and distributes profits and losses to its various shareholders (on Schedule K-1). The shareholders report their share of the income and losses on their personal income tax returns.
You can see that the tax status of your LLC is very different from its legal status. Understanding this concept is critical to understanding what an S corporation is and how it works.
What are the tax benefits of an S corp?
The primary tax benefits of electing S corporations status for your business depend on the facts and circumstances surrounding its current tax situation.
For example, suppose your business is currently a sole proprietorship.
Like a sole proprietorship, the net business income of an S corporation is reported on the tax return of its owner, so in this respect an S corporation doesn’t yield any savings on regular income taxes.
However, unlike a sole proprietorship, the business owner isn’t subject to self-employment taxes on net business income. Your self-employment taxes are roughly equal to 15.3% of net business income reported on Schedule C.
If you’re currently filing as a sole proprietor, electing S corporation status for a particular business activity will help you avoid self-employment taxes, which may lower your overall tax liability.
You should be aware that electing S corporation status precipitates additional compliance requirements for your business.
The IRS requires S corporations to pay shareholder-employees (i.e. you, the business owner) “reasonable compensation.” The shareholder-employee and S corporation pay employment taxes on the “reasonable compensation,” which is roughly equivalent to self-employment taxes.
The S corporation must also file its own tax return, maintain accurate books and records, and may be subject to state-level requirements as well.
In many cases, the tax savings of electing S corporation status more than offset the incremental employment taxes and compliance costs. Even so, careful planning is needed before making the election. There are numerous factors at play which may or may not yield overall savings.
For example, the salary you pay yourself as “reasonable compensation” through your S corporation decreases “Qualified Business Income,” which in turn makes your QBI deduction smaller than it would be if your business were taxed as a sole proprietorship.
This is but one consideration among many, which is why you should consult with a tax advisor prior to making the election.
How do I form an S corp?
Confirming that your business is an”eligible entity” is the first step to establishing your business as an S corporation.
Eligible business entities include:
- Domestic corporations;
- Partnerships with two or more members with or without an LLC;
- Single-member LLCs
If your business is a sole proprietorship or a general partnership, and you haven’t yet opened an LLC and obtained an EIN for your business, doing so would be your first step in electing S corporation status.
Your next step is to confirm that your business meets the ownership requirements:
- The business must have no more than 100 shareholders or partners.
- The business can't be a shareholder of another S corporation.
- Shareholders can't be nonresident aliens unless they're legal permanent residents of the United States under immigration law. If you're not a U.S. citizen, but you do have legal permanent resident status, then it's possible for you to own an S corp as long as you meet certain guidelines and restrictions on what type of compensation and benefits are available to employees who are not citizens or permanent residents (see IRS Publication 542).
Assuming your business is an eligible entity and meets all ownership requirements, your next step is to file Form 2553 with the IRS. Form 2553 can be faxed or mailed to the IRS. Carefully review Form 2553 before sending, as incorrect information will cause processing delays.
Also be mindful of when you file Form 2553. The IRS requires Form 2553 to be “timely” filed on or before the 15th day of the third month of the tax year in which the election should be effective.
For example, if it’s currently February and you’d like your sole proprietorship to be taxed as an S corporation for the current year, you’d need to file Form 2553 prior to March 15th of the current year. You’d still file as a sole proprietorship on Schedule C of your Form 1040 for the prior year.
You can file Form 2553 after the original due date, but the IRS considers this to be a “late election.” You’d need to include a statement explaining your “reasonable cause” for making the late election when filing Form 2553.
How do I file taxes as an S corp?
As an S corporation, your business must file Form 1120-S with the IRS by the 15th day of the third month following your company's year-end. For most S corporations, this date is March 15th.
Form 1120-S is the annual income tax return that all S corporations must file. It’s similar to Form 1040 (the form you file for personal income taxes) in that it’s filed once per year to report income and deductions, but it has different due dates, supporting schedules, and is typically not accompanied by an income tax payment or refund.
In lieu of paying income taxes, after filing Form 1120-S your S corporation will provide a Schedule K-1 to all shareholders. Each shareholder’s K-1 reports the share of the S corporation’s income and deductions that should be reported on the shareholder’s personal tax return.
An S corporation can file for an extension if it needs additional time to file Form 1120-S. This gives the S corporation an additional 6 months from its original due date to file its return and distribute Schedules K-1 to its shareholders.
Form 1120-S is more complex than your personal income tax return. Entering incorrect information can trigger unexpected tax consequences for its shareholders. Letting a knowledgeable tax professional file your S corporation tax returns will avoid common mistakes and set you up for success.
What do I do with my S corp K-1?
Schedule K-1 is an annual tax document that an S corporation provides to each of its shareholders. The shareholder’s K-1 reports tax information that must be reported on the shareholder’s personal tax return.
Certain deduction and income items incurred by an S corporation have unique tax treatment on the shareholder’s tax return. These items must be separately stated on the K-1 so that the shareholder can’t report these items appropriately on their personal income tax return.
For example, charitable contributions aren’t deductible business expenses and don’t reduce taxable income if reported on an S corporation’s tax return. Instead, charitable contributions are reported on Schedule K-1 for each shareholder to report as an itemized deduction on their personal tax return.
The Schedule K-1 also reports information related to the Section 199A “Qualified Business Income” deduction. This deduction is generally equal to 20% of a taxpayer’s total QBI across all businesses, subject to limitations and phaseouts, and is taken on an individual’s income tax return.
An individual shareholder reports S corporation income or losses on Schedule E of their tax return. You should differentiate between passive and non-passive income and losses earned by your S corporation on Schedule E. You should also include a basis calculation to track your investment in the S corporation year-over-year.
You can file your own tax return using TurboTax, but I'd recommend hiring a professional if this is your first year filing as an S corporation shareholder. Mistakes made in the first year will carry forward to other years and might result in costly mistakes.
Conclusion
Filing as an S corporation can be beneficial to certain small business owners due to the tax savings, but the rules around S corporations are complex. If you have any questions about filing as an S corporation, get in touch. We’ll walk you through the tax filing process and speak directly to your personal income tax situation.
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