If you’re going into business in the Blue Grass State, starting a Kentucky S corp could provide some tax benefits. But what exactly is an S corp, and how do you go about getting one? We’ll cover that and more in this article.
Despite how it sounds, an S corporation (S corp) isn’t a corporation or any other kind of business structure. Instead, it’s 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 and avoid paying Kentucky corporation income tax. 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 the right move for your business.
In this article, you can also learn learn more about S corps and their pros and cons.
For the IRS to accept your application for S corp classification, you must meet the filing requirements of the Internal Revenue Code. To qualify for S corporation status, your company must:
If your business entity falls within these parameters, congratulations — you can apply for an S corp election.
Before you can have your Kentucky S corporation, you’ll need to create either an 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 launch an LLC in Kentucky, first choose a name for your business that’s unique to Kentucky and follows the state’s naming guidelines. From there, designate a registered agent and file your Articles of Organization with the Kentucky Secretary of State. Write an operating agreement for your LLC to spell out how it will be organized and operated. Lastly, get an employer identification number (EIN) from the IRS. For details on these steps and more, visit our “Start a Kentucky LLC” page.
If you’d rather start your own corporation in Kentucky, there are more steps and paperwork involved. Follow the instructions on our Kentucky corporation page.
When your LLC or C corporation formation is approved by the state, you’ll need to file Form 2553, Election by a Small Business Corporation, with the IRS to get S corp election.
The IRS requires you to 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.
Note that all of the shareholders or members must sign the consent statement portion of the form. For more information on filing Form 2553, visit the IRS website.
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In an S corp, the business itself doesn’t usually pay federal income tax, just the individual owners. But what about Kentucky income taxes?
Kentucky does recognize federal S corp election, meaning that it will treat an S corp for state income tax purposes the same way the federal government treats it for federal income tax purposes. That being said, S corps and every other business that is protected from liability by the laws of the state must pay the Kentucky Limited Liability Entity Tax (LLET).
Whether your S corp is an LLC or a corporation, you’ll need to perform certain ongoing tasks to keep them in compliance. One of these is to regularly file a Kentucky annual report. This report is intended to keep the state informed about any changes to your business. For both LLCs and corporations, there’s a $15 filing fee for the report, and it’s due by June 30 each year. You’re also required to notify the state of any major changes to your business, such as changing your registered agent or your principal business address.
If your S corp was formed as a Kentucky 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 Kentucky are also required to hold annual shareholder meetings at a time and place established in the bylaws.
These may not be the only ongoing requirements for your Kentucky S corp. For example, you may have business licenses that need to be renewed regularly.
S corp status comes with a number of tax benefits for some businesses, but making this election might not be right for everyone. Weigh the pros and cons before deciding whether you want an S corp. Consult a tax professional about whether the S corp election would be best for your business.
If you have a C corporation, filing as an S corp has these tax advantages:
Traditional corporations are encumbered by “double taxation.” When the corporation makes money, the IRS taxes those profits on the business level. And when those profits are distributed to the shareholders, they’re taxed a second time on the shareholders’ personal tax returns.
When a C corporation becomes an S corp, though, those profits are only taxed at the individual 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, and so do the company’s losses. Unlike C corporation shareholders, 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 corp status also has its weaknesses for C corps:
As we said, an S corp can’t have more than 100 shareholders, while a C corporation has no restriction on the number of shareholders.
Corporations can sometimes use preferred stock to entice investors, but the IRS doesn’t allow this for S corps.
S corp shareholders must all be U.S. citizens, or certain trusts or estates. You also can’t have corporations or partnerships as shareholders.
Because of the extra limitations S corps have, the IRS looks at them more closely to see if they’re in compliance. Your corporation is more likely to get audited.
Having an S corp election brings other pros and cons for an LLC.
The benefits 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 advantages of S corp tax designation for an LLC come from federal self-employment tax. We’ll explain.
The members of an LLC are usually considered self-employed. They’re compensated by receiving their share of profits from the LLC, but they can’t be employed by 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.
But when the members elect S corp status, they get to be compensated in two ways, by receiving their share of the profits and by being an employee of the LLC. Once they do that, 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. (Note that the members will still pay income tax 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.
Here’s the 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 $0.14 and avoid contributing anything to Social Security and Medicare.
So, what is a “reasonable” salary in the eyes of 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 similar work.
LLCs with S corp status can have its minuses, though:
Having an LLC that files as an S corporation means more paperwork and red tape. 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.
You must meet more requirements with an S corp than with a standard LLC. An S corp can have no more than 100 members, and none of them can be partnerships, corporations, or non-resident aliens. A traditional LLC doesn’t have these limitations.
Because of the “reasonable salary” restrictions, the IRS monitors closely LLCs filing as S corps. That could mean a greater chance of being audited.
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 Kentucky, follow these steps:
If you prefer to have a Kentucky C corporation with S corp election, follow our instructions for forming a corporation and then file Form 2553.
If an S corporation has filed for an extension with the federal government, the state of Kentucky will also automatically grant the extension of time to file in Kentucky.
Yes. The corporate income tax rate in Kentucky is a flat 5%.
The minimum tax in Kentucky is $175 (based on the Limited Liability Entity Tax) for gross profits of $3 million or less.
For more information about how S corps are treated in Kentucky and other important tax info, see the Kentucky Department of Revenue website. The IRS website can provide additional information on the federal guidelines for S corporations. Whenever you have questions, we recommend having a trusted tax professional by your side. They can guide you through legal and financial 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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