If you’re an entrepreneur in the Old Line State, starting a Maryland S corp could be a way to save on taxes. But what exactly is an S corp, and how do you go about getting one? We’ll cover that and more in this article.
First, you need to understand what an S corporation (S corp) is. Despite how it sounds, it’s not a type 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. We’ll outline those criteria and the steps you would need to take to file as an S corp if you decide that it’s right for you and your business.
Learn more about what an S corp is.
For the IRS to accept your application for S corp election, you must meet the filing requirements of the Internal Revenue Code. Specifically, to qualify for S corporation status, an entity must:
Not all business entities are eligible for S corp election. However, if your business entity falls within these parameters, you can apply for an S corp election.
To start a Maryland S corporation, you’ll need to create either a limited liability company (LLC) or a C corporation if you haven’t already done so. Then, you’ll file an election form with the IRS.
To form an LLC in Maryland, first choose a name for your business that’s unique to Maryland and follows the state’s naming guidelines. From there, designate a resident agent and file your Articles of Organization. Write an operating agreement for your LLC to spell out how it will be run and organized. Finally, get an employer identification number (EIN) from the IRS. For more details on these steps, visit our “Start a Maryland LLC” page.
If you’d rather form a Maryland corporation, follow the instructions on our Maryland corporation page.
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:
One caveat 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/members must sign the consent statement portion of the form. For more information on when and how to file Form 2553, visit the IRS website.
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In an S corp, the business itself doesn’t usually pay federal income taxes. But what about Maryland income taxes?
S corporations in Maryland must file Maryland Form 510, Pass-Through Entity Income Tax Return, if the business is formed or incorporated in Maryland, does business in Maryland, or has Maryland income or losses. Each S corp member then has to file the applicable Maryland income tax return and pay any tax due on the member’s distributable or pro-rata share of the pass-through entity’s items for the tax year.
You don’t need to pay Maryland income tax with Form 510 unless you’re subject to the nonresident member tax. If your S corp has a nonresident member and any nonresident taxable income, then the business is subject to the Maryland income tax. The S corp is taxed on the nonresident taxable income, which is the total of the nonresident members’ distributive or pro-rata shares of the S corp’s income allocable to Maryland.
Whether your S corp is an LLC or a corporation, you must file an annual report. Most LLCs and corporations have to pay a $300 filing fee. Only three entities are exempt:
Additionally, corporations have to fill out a separate section of their annual report. Section II provides the names and mailing addresses of all corporate officers and corporate directors. A corporation with S corp election must also hold an annual meeting of its stockholders to elect directors and transact any other business within its powers, just as any Maryland corporation would.
While S corp status does come with a number of benefits for some businesses, making this election might not be right for everyone. Carefully weigh the pros and cons before deciding how you want to proceed. Consult a tax professional about whether the S corp election would be best for your business.
If you have a C corporation (the default form of corporation), filing as an S corp has these advantages:
One big disadvantage for traditional corporations is “double taxation.” When the corporation makes money, the IRS taxes those profits on the business level on a corporation income tax return. 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 level. The business itself isn’t taxed on them. This is called “pass-through taxation.”
Just as business profits pass through to the owners of an S corp, 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.
Under the 2017 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 downsides for C corps:
As we said, an S corp can’t have more than 100 shareholders, while a C corporation has no such restriction.
All S corp shareholders must be U.S. citizens, or certain trusts or estates. That could limit your ability to expand internationally. You also can’t have corporations or partnerships as shareholders.
One way corporations attract investors is to offer preferred stock, but the IRS doesn’t allow this for S corps.
Because of the extra limitations S corps have, 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 pros and cons 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. A traditional LLC already has pass-through taxation, so the benefits of S corporation election for an LLC come from federal self-employment tax. We’ll explain.
The members of a standard LLC are 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 can be compensated in two ways, by receiving their share of the profits and by being employed by 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. (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 provision to this is that 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 $0.03 and avoid contributing anything to Social Security and Medicare.
So, what is “reasonable compensation”? 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 drawbacks, though:
S corps have more qualifying conditions than 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 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 generally 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.
Maryland does recognize federal S corp election and doesn’t require you to make a separate election at the state level.
You’ll need to set up either an LLC or a C corporation (if you haven’t already done so). Then you’ll need to file Form 2553, Election by a Small Business Corporation, with the IRS to get S corp status.
A C corp is the default form of corporation and is a separate legal entity from its owners. An S corp is only a tax election that an LLC or C corporation can make.
An LLC is a legal business entity, but an S corp is a federal tax election that an LLC or corporation can file for.
Are you ready to form an LLC with an S corp election? Our S corp service can help you do that. Plus, we offer other services to help you run and grow your business and stay in compliance. Contact us today to get started and make your dream business a reality.
For more information about how S corps and other pass-through entities are treated in Maryland and other important tax information, see the Maryland State Comptroller website. The IRS website can also provide more information on the federal guidelines for S corporations. We recommend having a trusted tax advisor or accountant. They can help you through legal and financial challenges, helping ensure compliance and tax efficiency.
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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