Anyone starting a new business is faced with a lot of decisions. Arguably the most important is choosing the business entity type and tax status. Business lawyers and CPAs will present entrepreneurs with several options to choose from depending on the legal entity, including “S” election.
Each type of legal entity has its benefits and limitations. Technically, there’s no legal entity called an “S-Corp.” A company that makes an “S” election for tax purposes is typically referred to as an S-Corp. However, various types of legal entities including LLCs and Corporations can elect S-Corp status. This blog will discuss the benefits of “S” election.
What businesses are eligible for S-Corp status?
Some types of businesses are ineligible for S-Corp status, including certain financial, insurance, and international businesses.
S-Corps can have no more than 100 shareholders. This could potentially affect the company’s future growth, so it is a serious consideration for startup founders. The IRS has a strict definition of who can be a shareholder:
- Shareholders must either be U.S. citizens or resident aliens.
- Partnerships and corporations cannot be shareholders.
- The S-Corp cannot issue more than one class of stock.
- In certain circumstances, family members, spouses, or their estates may be lumped together and considered “one shareholder” by the IRS. This loophole provides some flexibility for growth.
The decision to elect S-Corp status must be a unanimous one. All shareholders must sign off on IRS Form 2553.
When is an S-Corp the right choice for a business?
LLCs and Corporations can elect S-Corp status. One of the biggest advantages with respect to a corporation is that shareholders report the corporation’s income, losses, credits, and deductions on their personal income taxes. This “pass-through” taxation allows the shareholders to be taxed at their own individual income tax rates and prevents double taxation on the business’s income that would typically happen as a C-Corp.
S-Corps must pay their employees a reasonable salary. These salaries can be deducted from the shareholder’s distribution, so it’s important to make an accurate salary calculation to avoid trouble with the IRS. The distributions are not subject to employment taxes or self-employment taxes, which could save the owner of the S-Corp a substantial amount of money.
What is the difference between S-Corp and Partnership Taxation?
Single-Member or Multi-Member LLCs can elect “S” status. If the LLC doesn’t elect S-Corp status, the LLC will either be taxed as a disregarded entity (Single-Member LLC) or be taxed as a partnership (Multi-Member LLC). Assuming the LLC doesn’t elect “S” status, the most significant differences revolve around tax treatment and maintenance.
LLCs have pass-through taxation either as a disregarded entity for single-member LLCs or as a partnership for multi-member LLCs. S-Corp status for many businesses may be more tax-efficient if their business is profitable year-over-year. This is because owners of an S-Corp pay FICA taxes and income tax on their salary but only pay income taxes on their distributions. The member(s) of an LLC will pay self-employment taxes and income tax on any profits and distributions.
In terms of maintenance and operations, LLCs are easy to set up and have much less “red-tape” than S-Corps (see ownership restrictions above). LLCs are typically easier to set up and cheaper than corporations, and the operation of an LLC is not subject to as much scrutiny as an S-Corp. The owner of a single-member LLC doesn’t need to file a separate document with the IRS for tax purposes, but instead can use Schedule C on their personal income tax return.
New York State Requirements for S Corporations
New York State does recognize S-Corps at the state level, but not all states (or cities) do. To be recognized as one in New York State, the business must first be established as such at the federal level. Meaning, if you didn’t file federal taxes as an S-Corp, you won’t be able to file taxes as one in New York.
Other steps must be taken to be established as an S-Corp:
- All shareholders must agree to have the S-Corp recognized in NYS.
- The business must be taxable under Article 9A of the New York State Tax Law.
- To request S-Corp status, the business must file form CT-6. Processing this form may take up to two months, and applications can be denied for insufficient or incorrect information.
In New York State, federally recognized S-Corps that don’t qualify for S-Corp status or don’t apply for S-Corp status, are taxed as C-Corps at the state level.
Is an S-Corp the right choice for my business?
Choosing an entity type or tax status for your business is no small undertaking. Some of the items you need to think about before deciding to elect “S” status are:
- The amount of taxes you pay
- State S-Corp recognition
- Who can be a shareholder
- Your options for future growth
- Disruptions when shareholders leave
- How much money will be left over for distributions
- How much you plan on re-investing into your business
At the Law Office of Elliott J. Brown, we are well-equipped to advise you on your business entity options. Our corporate attorneys will leave no stone unturned, ensuring you have the information you need to move forward. Please contact us to set up an appointment.
This blog post is not tax advice. The attorneys at the Law Office of Elliott J. Brown are not tax attorneys or CPAs. You should consult with a tax advisor or CPA before making a decision on any tax-related matters.
What is an S Corp?
An S-Corp is a closely held legal entity (corporation, LLC, etc..) that makes a valid election under Subchapter S of Chapter 1 of the Internal Revenue Code.