When an S corporation election pays off, and how to make it

What does the election change?

For a sole proprietor (including a single-member LLC) or a partnership, profit still passes through to the owners' income tax returns. The main change is Social Security and Medicare tax: an owner who works in the business becomes its employee and takes a salary through payroll. Distributions beyond that salary are not subject to employment taxes (IRS). That gap is the main saving.

For a C corporation, the election instead generally ends the 21% corporate income tax and the second tax on profit paid out as dividends, because profit passes through to the shareholders (IRS, IRS). Its working owners are already employees on payroll (IRS), so the self-employment tax comparison below does not apply.

Shareholders owe tax on their share of income even if it stays in the business (K-1 instructions). The S corporation itself generally pays no federal income tax, but it can owe tax on certain built-in gains and passive income, mostly an issue for a former C corporation (IRS).

Who can elect?

A domestic corporation can, and so can a domestic LLC or other entity that can choose to be taxed as a corporation, if it passes every test below. An LLC that files Form 2553 is treated as a corporation from the election's effective date and does not also file Form 8832 (Form 2553 instructions). A sole proprietorship is not an entity, so it cannot elect; it would first form an LLC or corporation.

The election ends automatically on the day the corporation no longer meets the shareholder, stock or type-of-business tests, for example when a nonresident alien acquires shares (Form 1120-S instructions). One class of stock also means profit follows share ownership: an LLC with two or more owners cannot keep special profit splits after electing. Its operating agreement must give every ownership unit identical rights to distributions and liquidation proceeds (26 CFR 1.1361-1(l)(2)).

How do I make the election?

File Form 2553 with the IRS by mail or fax, to the address or fax number listed for your state in the Form 2553 instructions.

1. Get an employer identification number (EIN) for the LLC or corporation if it has none. A sole proprietor's own EIN cannot be used (IRS).
2. Complete Form 2553: the effective date (item E), the tax year, each shareholder's shares or ownership percentage and taxpayer ID, and each shareholder's signed consent (column K). A corporate officer signs; an unsigned form is not timely filed.
3. File on time: no more than 2 months and 15 days after the tax year the election is for begins, or at any time in the tax year before. For an existing calendar-year business, that means by March 15 for the election to start January 1. A new business counts from the earliest of the day it first had shareholders, had assets or began doing business.
4. Keep proof of filing: a certified or registered mail receipt, a copy stamped received or accepted, or the IRS acceptance letter.
5. The IRS should answer within about 60 days, or about 90 days more if you checked box Q1 to ask for a different tax year for a business reason. If you hear nothing within 2 months (5 months with box Q1), follow up with the IRS.
6. Keep filing the business's current return type until the election takes effect.

Once made, the election stays until it ends or is revoked. After that, the business generally needs IRS consent to elect again before the fifth tax year after the year it ended.

What if I missed the deadline?

A late election generally starts the following tax year. Rev. Proc. 2013-30 lets the IRS accept it for the intended year if all of these hold:

• The business meant to be an S corporation from the date on the form, and failed only because the form was late.
• It had reasonable cause and acted promptly once it found the mistake, and explains both on the form or an attached statement.
• It files within 3 years and 75 days of the intended effective date.
• Every person who was a shareholder in the meantime states they reported income consistently with S status. The consents in column K cover this.

An LLC must also have filed every Form 1120-S on time, or not yet reached the first one's due date. Write "FILED PURSUANT TO REV. PROC. 2013-30" at the top of the form. A corporation that meets the other conditions but is past 3 years and 75 days may still qualify if it and all shareholders reported consistently with S status every year, at least 6 months have passed since it filed its first S return, and the IRS raised no problem within 6 months of that return being timely filed. An LLC whose late Form 2553 is also its choice to be taxed as a corporation cannot use this route. Otherwise, the business generally must request a private letter ruling and pay a user fee (Form 2553 instructions).

What salary do I have to pay myself?

A reasonable salary for the work you do, paid before you take other distributions (IRS). Neither the tax code nor the regulations define the amount; courts decide on the facts. They have looked at (IRS fact sheet):

• Training and experience
• Duties and responsibilities
• Time and effort spent on the business
• Dividend history
• Pay to employees who are not shareholders
• Timing and manner of bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• Use of a formula to set pay

The salary never has to exceed what you actually take from the business, directly or indirectly. Once you take cash or property, a reasonable salary must be set (IRS fact sheet). The IRS can reclassify distributions, paid personal expenses and "loans" as wages, and courts have agreed, including where the owner paid a salary that was too low (IRS).

How much self-employment tax is at stake?

Self-employment tax is 15.3% of 92.35% of net profit, in two parts (IRS, Form 1040-ES):

Salary from an S corporation carries the same two taxes, half paid by the corporation and half withheld from your pay (Publication 15). So the saving comes only from profit that is not paid as salary.

When does it break even?

If you have no other wages, and while 92.35% of net profit stays below $184,500:

Yearly saving ≈ 15.3% × (92.35% of net profit − salary) − added yearly costs

Put simply, the gap between 92.35% of profit and a reasonable salary must be about six and a half times your added yearly costs just to break even. Earnings above the wage base carry only the 2.9% Medicare part, so profit above it adds little to the saving. Wages from another job count toward the same wage base, so they can shrink or erase the saving (IRS).

The formula leaves out income tax effects, including a smaller qualified business income deduction (below), the deduction for half of self-employment tax and the corporation's deduction for its share of payroll tax. The real difference shows only when a full return is prepared both with and without the election.

What does it do to the qualified business income deduction?

Salary from your S corporation is not qualified business income (Form 8995 instructions), so moving profit into salary can shrink that deduction. At higher incomes the deduction can be capped by the W-2 wages the business pays, which include your salary (Form 8995-A instructions). The net effect depends on your income.

What costs eat into the saving?

• Unemployment tax on the salary: federal (Form 940) and usually state (Publication 15). Social Security and Medicare tax on the salary is already in the formula above.
• Running payroll: withholding, quarterly Form 941, yearly Form 940 and a Form W-2 for you (IRS).
• Form 1120-S every year, due by the 15th day of the 3rd month after the tax year ends, with a K-1 for each shareholder. Filing late brings a penalty for each shareholder for each month, even when no tax is due (Form 1120-S instructions).
• Basis records: each shareholder tracks stock basis (roughly, what they put in plus income taxed to them, minus losses and distributions) and debt basis (money they lent the corporation themselves). Distributions are tax-free only up to stock basis; losses are deductible only up to stock plus debt basis. Unlike a partner, a shareholder gets no basis from the business's bank loans or from personally guaranteeing them (IRS, Publication 541).
• Health insurance: an owner keeps deducting health insurance premiums only if the S corporation pays or reimburses them and reports them as W-2 wages, and the deduction is limited to the owner's salary from the S corporation (Form 7206 instructions).
• Retirement contributions: plan contributions are based only on your salary; distributions do not count (IRS).
• Costs you pay yourself: as an employee you cannot deduct home office, car or other work costs on your own return. The S corporation can reimburse them tax-free under an accountable plan (Form 2106 instructions, Publication 463).
• State tax, which varies. California, for example, taxes S corporations 1.5% of California income, with an $800 minimum franchise tax each year (FTB). Some states need their own election: New York taxes a business that files only Form 2553 like a regular corporation unless it also files Form CT-6 (NY Tax), and New York City does not recognize S status at all (NYC Finance).

When does it usually not pay off?

• Profit close to a reasonable salary. Little is left to save on after costs.
• Low, uneven profit or losses. Costs come every year. A loss year has no self-employment tax to save, and shareholders deduct losses only up to their stock and debt basis (IRS).
• A C corporation with loss carryforwards or qualified small business stock. Losses from its C corporation years cannot be used in S years (26 U.S.C. 1371(b)), and stock qualifies for the section 1202 gain exclusion only if the business stays a C corporation for substantially all of the time it is held (26 U.S.C. 1202(c)).
• A shareholder who lives in Canada, such as a US citizen there. Canada may not give full credit for the US tax on the S corporation's profit, so the same profit can be taxed in both countries. Canada does not treat the business as carried on by the shareholder, so that US tax cannot count as business-income tax for the foreign tax credit, only possibly as non-business-income tax (CRA Folio S5-F2-C1, ¶1.27). The treaty lets such a shareholder ask Canada's tax authority (its competent authority) to treat the S corporation differently (Article XXIX, paragraph 5). Get cross-border advice before electing; see a US business for a Canadian resident.

Example

Illustrative only; figures in US dollars. A sole proprietor has $120,000 of net profit. She forms a single-member LLC and elects S status. Assume $60,000 is a reasonable salary for her work, and a payroll service and Form 1120-S preparation add $3,000 a year.

She comes out about $4,775 a year ahead before income tax effects. The formula gives the same: 15.3% × ($110,820 − $60,000) − $3,000. At her income, the salary also shrinks her qualified business income deduction, which raises her income tax and cuts noticeably into this saving. If a reasonable salary for her work were $95,000, the election would cost about $580 a year more than it saves. A California business would also owe the state's S corporation tax, generally at least $800 a year.

Different for you?

• You live in Canada, or plan to. See a US business for a Canadian resident and Americans living in Canada.
• You are a Canadian owner of a US LLC. See Canadian owner of a US LLC.
• An owner is a nonresident alien (not a US citizen or tax resident). The business cannot elect. See foreign-owned single-member LLC filing.
• You already file Form 1120 as a C corporation. See tax preparation.
• You need an LLC or corporation first. See business formation.
• You need books kept, or want to ask about payroll. See bookkeeping.
• You missed the Form 2553 deadline, or want your return prepared both ways. See tax preparation.