If you have organized your business as a corporation, you have a choice as to how your business will be taxed by the Internal Revenue Service (IRS). It can be taxed as either a C corporation (or C corp.) or an S corporation (or S corp.).
What is an S corp.?
An S corp. is a corporation that is taxed like a sole proprietorship (if there is only one shareholder) or a partnership (if there are two or more shareholders). The corporation itself does not pay any tax, but the profits are passed on to the shareholders. The shareholders then report the income on their individual income tax returns. Not all corporations can file for S corp. status. For example, the corporation cannot have more than 100 shareholders and must be a closely held corporation (i.e., one that does not have publicly traded shares).
Why is it called an 'S' corporation?
The provision of the IRS regulations that covers this method of taxation is Subchapter S of Chapter 1 of the Internal Revenue Code. A corporation using the Subchapter S method is commonly called an “S corporation," an “S corp.," or a “Sub S corp."
What is an S corp. election?
If you organize your business as a corporation and do nothing else, it will be taxed as a C corp.
In order to have it taxed as an S corp., you need to notify the IRS that you are choosing, or “electing," to have it taxed as an S corp.
What are the benefits of electing S corp. status?
The benefit of electing S corp. status is avoiding what is commonly called “double taxation."
A C corporation is required to file Form 1120, U.S. Corporation Income Tax Return. Any profits will be taxed at the corporate tax rate. If any portion of those profits is passed on to the shareholders as dividends, each shareholder will need to report his or her share on their individual Form 1040, along with Schedule B, Interest and Ordinary Dividends.
Therefore, the profits are taxed once to the corporation, then taxed a second time to the shareholders if any profits (dividends) are distributed to the shareholders. This is known as “double taxation."
An S corporation is required to file Form 1120S, U.S. Income Tax Return for an S corporation. Unlike the C corp., no corporate tax is assessed on any profits reported on Form 1120S. Instead, the profits are divided among the shareholders, according to the number of shares held by each shareholder.
Each shareholder will then need to report his or her share of the profits on their individual Form 1040, along with Schedule K-1 (Form 1120S), Shareholder's Share of Income, Deductions, Credits, etc. However, the profits are taxed to the shareholders even if no dividends are distributed to them.
How do you make an S corp. election?
If you want to make the S corporation election, you need to file IRS Form 2553, Election by a Small Business Corporation. If you file Form 2553, you do not need to file Form 8832, Entity Classification Election, as you would for a C-Corporation. You can file your Form 2553 with the IRS online, by fax, or by mail. For more detailed information about S corporations and making the election, see Instructions for Form 2553, available at www.irs.gov.
How long do you have to make an S corp. election?
An S corp. election can be made by filing Form 2553 no later than two months and 15 days after the beginning of the corporation's tax year.
As stated in the instructions for Form 2553, “the 2-month period begins on the day of the month the tax year begins and ends with the close of the day before the numerically corresponding day of the second calendar month following that month. If there is no corresponding day, use the close of the last day of the calendar month."
If you currently have a C corp., and wish to change to an S corp. for the next tax year, you can also file at any time during the current tax year.
Making a decision
Making an S corp. election is a fairly simple matter. However, deciding whether to make the election requires consideration of several factors, including the amount of anticipated profits, whether dividends will be distributed to shareholders, whether you have employees, the benefits offered to employees, and how your state will tax the corporation.