When you form a corporation, by default, the IRS treats the company as a C corporation. However, it can elect to become an S corporation for taxation purposes as long as the business meets IRS requirements, which we’ll discuss shortly. LLCs can also opt to be taxed as S corps. Businesses must file Form 2553 — Election by a Small Business Corporation — to make this change.
Filing Form 2553 offers advantages in terms of tax treatment for a corporation or LLC. Let’s look at the difference between how a C corporation and an S corporation are taxed, then we’ll examine the differences between S corps and LLCs.
The IRS treats C corporations as separate, tax-paying entities. The corporation itself pays corporate income taxes on profits at the corporate tax rate. Then, shareholders pay personal income taxes on any dividends they receive. These shareholder taxes are calculated at the individual’s personal tax rate. This process is known as double taxation because it essentially taxes the same income twice.
S corporations, on the other hand, are considered pass-through entities. Any profits, losses, credits, and deductions pass through to the owners, who report everything on their personal tax returns. The S corporation doesn’t pay its own income taxes. Instead, the owners pay taxes on this money on their personal income tax. This tax treatment is called pass-through taxation. Small business owners find this method of taxation advantageous because they often pay less in taxes and have more money left to reinvest back into the company.
How does S-corp taxation differ from standard partnership-style taxes for an LLC? The major difference is in regard to self-employment taxes. LLC members have to pay self-employment taxes (both the employee and employer shares of Medicare and Social Security) on all net earnings.
With S-corp taxation, you’d only pay self-employment taxes on your salary. That said, traditional LLC taxation provides more opportunities for deductions, so it can be a better option for many businesses. If you’re wondering which form of taxation is better for your LLC, contact an accountant.
Not all businesses can file Form 2553 and make an S corporation election. The IRS has strict requirements and limitations.
For a corporation or LLC to qualify for S corporation status, it must:
For more details about the IRS’s requirements, read through the Instructions for Form 2553 posted on the IRS website.
Depending on when you want the election to take effect, you can file Form 2553 at two different points during the year. If you want the election to be effective during the current tax year, you must file Form 2553 within the first two months and 15 days of the year. If you file the form anytime after that, the S corporation status will go into effect during the next tax year.
Check out the instructions for Form 2553 for examples of the different filing times. In limited situations, the IRS makes exceptions for late filings. Keep in mind that your state may require you to file additional forms, so check with your state’s Secretary of State and Department of Taxation for more information.
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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.