S Corps: Why You Should Consider An Election

There usually comes a time when a successful small business owner wishes to become an S corp for business or legal reasons. Many business owners are unaware of a business structure that often results in significant tax benefits.  Taking the S corp election shouldn’t come lighty.  There are several things you must consider before taking that jump! 

What happens when you take an S corp election

When you elect S corp status with the IRS, you are declaring your business as a separate and distinct entity from your personal finances. After the IRS has approved the election, your business operates under the S corp status as long as it continues to meet the necessary requirements.  According to the IRS, these are the requirements needed to become an S corp:  

  • Must be a domestic corporation that has only allowable shareholders.  
  • Must have no more than 100 shareholders and only one class of stock.  
  • Not be an ineligible corporation.

Advantages of an S corp

Taking the S corp election comes with several advantages.  One of the most important things that every business likes to hear is that it eliminates double taxation.  Profits and losses are passed through to the shareholders and taxes are only paid once. Another advantage is that as the owner of an S corp, your personal assets are separate from the business’s assets and are therefore protected in case any judgments occur against the business.  There is straightforward transfer of ownership and S corps, without any inventory, can use the cash method of accounting.

Reasons to think twice

Taking the S corp election isn’t for everyone.  There are some aspects that companies need to think about before making the election.  S corp requirements can be tricky to navigate and elections are known to be fragile as all shareholders must agree to the election.  The paperwork associated with the regular S corp  filings can be tedious, onerous, and often confusing. A few simple mistakes can cause your company to lose its S corp status and risk your company being taxed as a C corporation. 

One really important thing to remember is that it is extremely hard to opt out of an S corp.  All members of the LLC must agree to the revocation and the LLC must give proper written notice to the IRS.  To revoke the S corp status effective at the beginning of the current tax year, the revocation notice must be received by the IRS no later than the 16th day of the third month of the tax year.  If you decide to revoke at mid tax year, there may require additional form filings, with accompanying accounting complications.  Once revoked, you must wait at least 5 years to elect in again.  Then you are required to file a number of official state and federal documents, including Articles of Incorporation and corporate minutes. You must also hold regular shareholder meetings and pay the required government fees.  The last and I would say one of the most important things to think about is that the IRS requires all owners of an S corp to earn a salary, even if the company is not yet making a profit. This could be a problem for new businesses struggling to make payroll.  A “reasonable salary” is what a person with the appropriate skills needed for the position would be paid on the free market.

Things to remember

So after looking at the advantages and disadvantages of an S corp you must remember a few things.  When considering taking the election, you must first make sure your company is profitable.  As a reminder, to check  if you are profitable you need to take your revenues and deduct your expenses.  If that number is positive you are profitable.  We like to see our clients makeover $40,000 in profits before we consider this election.  

Additionally, S Corps are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.  If you want your S Corp status to take effect quickly, you only have 2 months and 15 days from the beginning of the tax year to take your election into effect and file your Form 2553.  If you want your S Corp status to be effective next year, you can simply file Form 2553 anytime in the preceding tax year.

It’s always wise to consult with a tax expert and legal advisor to ensure you are making the best decisions for your business. For assistance forming an S Corp and minimizing your tax liability, reach out to one of our experts today.