Are you an Alabamian entrepreneur looking for a way to lower your tax burden? Starting an Alabama S corp could be the ticket. But first, you’ll need to understand what an S corp is, how it affects your taxes, and how you go about forming one. Read on for the answers to those questions.
First, understand that an S corporation (S corp) isn’t a type of business structure. “S corporation” refers to a federal tax classification that either a limited liability company (LLC) or a corporation can apply for with the Internal Revenue Service (IRS) if it meets the right criteria. For a corporation, S corp election is a way to avoid double taxation. For an LLC, it can be a way to save on self-employment taxes.
Not every LLC or corporation will qualify to be an S corp, though; they must meet the conditions of the Internal Revenue Service (IRS) first. We’ll list those criteria and the steps you would need to take to file as an S corp, provided you decide that it’s a good move for your business.
Later in this article, you can learn more about S corps and how they affect your taxes.
To become an S corp, you must first meet the filing requirements of the Internal Revenue Code. To qualify for S corporation status, your company must:
Business entities that fall within these parameters can become an S corp.
Before you can get your S corp off the ground, you’ll need to create either a limited liability company (LLC) or a C corporation (the default form of corporation) if you haven’t already done so. Then, you’ll file an election form with the IRS.
To form an Alabama LLC, you’ll first need to come up with a distinct name for your business that’s unique to Alabama and follows the state’s naming rules. Next, you’ll designate a registered agent and file your Certificate of Formation with the state. Set into writing how your LLC will be organized and run with an operating agreement. Then, get an employer identification number (EIN) from the IRS. For more details on these steps and more, visit our “Start an Alabama LLC” page.
If you’d rather form an Alabama corporation, there are more steps involved. Follow the instructions on our Alabama corporation page for guidance.
When your LLC or C corporation formation is approved by the state, you need to file Form 2553, Election by a Small Business Corporation, with the IRS to get S corp status.
The IRS requires that you complete and file your Form 2553:
For LLCs wishing to file as an S corp: If your LLC is past the 75-day election deadline, you’ll also need to file Form 8832, Entity Classification Election, to elect to be taxed as a corporation. Then you would file both Form 8832 and Form 2553 together via USPS-certified mail.
All of the shareholders or members must sign the consent statement portion of the form. For more information on when and how to file Form 2553, see the IRS website.
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In an S corp, the business itself doesn’t usually pay federal income taxes, just the individual owners. But what about Alabama income taxes?
If the federal government accepts your business as an S corp for federal income tax purposes, Alabama also accepts it as an S corp for state income tax purposes. That means that an S corp won’t pay state income taxes on its profits, just its owners. However, you must submit Form 20S to the state government for it to accept your business as an S corp.
All Alabama S corps are required to annually file the Alabama Business Privilege Tax Return and Annual Report for Pass-Through Entities (Form PPT). Many states require an annual report to update the state on basic information about a business, but Alabama is unusual in that it combines this report with a tax return for its Business Privilege Tax. Alabama also requires S corps to attach the Alabama Secretary of State Corporation Annual Report (Schedule AL-CAR) to Form PPT. It requests basic contact information related to the business and its leaders.
If your S corp was formed as an Alabama corporation, you’ll need to keep records of the minutes of meetings, all actions taken by the shareholders and board of directors, and all actions taken by committees on behalf of the corporation.
Corporations in Alabama are also required to hold annual shareholder meetings at a time and place established in the bylaws and notify shareholders at least 10 days (but no more than 60 days) before the meeting date.
Note that these are likely not the only ongoing requirements for your Alabama S corporation. For example, you may have business licenses and permits that need to be renewed regularly.
While S corp tax status can lower the tax bill for some companies, making this election might not suit everyone. Consider the pros and cons before deciding how you want to proceed. Consult a tax professional about whether S corp election would work well for your business.
If you have a C corporation, consider these advantages of S corps:
One big disadvantage for traditional corporations is “double taxation.” When the corporation makes a profit, the IRS taxes those profits on the corporate level. And when those profits are distributed to the shareholders, they’re taxed a second time on the shareholders’ personal tax returns.
But when a C corporation qualifies to be an S corp, those profits are only taxed at the individual owners’ level. The business itself isn’t taxed on them. This is called “pass-through taxation.”
Business profits pass through to the owners of an S corp, but so do the company’s losses. Unlike the shareholders of a C corporation, S corp owners can write off the business’s losses on their personal income statements.
Thanks to the Tax Cuts and Jobs Act, some S corp owners may be able to deduct up to 20% of their qualified business income. This deduction isn’t available to C corporation shareholders.
Qualified business income (QBI) is basically your share of the company’s profits, or, as the IRS puts it, “QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts.” The IRS website has a detailed explanation as to what is and is not included in QBI. There’s an income threshold that, if exceeded, may reduce your QBI (see the IRS website for details).
S corporation status also has its downsides for C corps:
As we said, an S corp has a cap of 100 shareholders, while a C corporation has no such restriction.
One way corporations attract investors is to offer preferred stock, but the IRS won’t allow this for S corps.
S corp shareholders must be U.S. citizens, or certain trusts or estates. That could limit your ability to expand. You also can’t have corporations or partnerships as shareholders.
Because of an S corp’s limitations, the IRS watches them more closely to see if they’re in compliance. Thus, your corporation is more likely to get audited.
Having an S corp election brings a different set of advantages and disadvantages for an LLC.
The advantages of filing as an S corp for an LLC aren’t exactly the same as they are for C corporations. An LLC already has pass-through taxation by default, so the benefits of S corporation election for an LLC come from federal self-employment tax. We’ll explain.
The members of a typical LLC are considered self-employed. They’re compensated by receiving their share of profits from the LLC, but they can’t be employees of the LLC. Being self-employed means paying self-employment taxes (Social Security and Medicare, which add up to about 15.3%) on all profits they receive from the LLC. This is double the taxes they’d pay when working for someone else because their employer would pay half of them.
However, when the members get S corp status, they can be compensated in two ways, by receiving their share of the profits and by being employed by the LLC. Then they only pay taxes for Social Security and Medicare on their salary and not the profits they receive. Depending on factors such as how profitable your company is, the savings could add up to a lot. (Of course, the members will still pay income and all other applicable taxes on their share of the profits and any other taxable income.) Money paid out as salary is a tax-deductible expense for the business.
One catch: the IRS expects you to pay yourself a “reasonable salary” as an employee of the LLC. Otherwise, you could pay yourself an annual salary of $0.12 and avoid contributing anything to Social Security and Medicare.
So, what is “reasonable” compensation to the IRS? While the terms aren’t 100% defined, the IRS seems to consider “reasonable” to be something similar to what others in your field are earning for doing similar work.
Having an LLC with S corp status can have its drawbacks, though:
Because of the “reasonable salary” restrictions, the IRS examines LLCs filing as S corps more closely. That could mean a greater chance of being audited.
Having an LLC that files as an S corporation means more paperwork. If you don’t already have to do payroll for your business, being an owner-employee means that you’ll have to start. Your taxes will be more complex, as well.
S corps have more restrictions than a standard LLC. An S corp can’t have more than 100 members, and none of them can be partnerships, corporations, or non-resident aliens. A traditional LLC doesn’t have these limitations.
If the federal government recognizes your business as an S corp for federal income tax purposes, Alabama will recognize you as an S corp for state income tax purposes. However, you’re required to file Form 20S with the state.
To become an S corp, you must first have either an LLC or a C corporation. To start an LLC with S corporation status in Alabama, follow these steps:
If you prefer to have an Alabama C corporation with S corp election, follow our instructions for forming a corporation and then file Form 2553.
An LLC is a separate legal business entity, but an S corp is just a federal tax election that an LLC or corporation can apply for.
Owners of an Alabama S corp must file Form 20S.
Do you want to form an Alabama LLC with an S corp election but need some guidance? Our S corp service can handle the process for you. Plus, we offer other services to help you run and grow your business and escape the red tape. Get in touch with us today and take the next step to making your dream business a reality.
For additional information about how S corps are treated in Alabama and other important tax info, see the Alabama Department of Revenue website. The IRS website can also provide more information on the federal guidelines for S corporations. We recommend having a trusted tax professional by your side. They can guide you through the financial and legal challenges so that you can stay in compliance while maximizing your tax savings.
Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
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