This guide will help you to understand s corporation taxation quickly and in simple English. See if forming an s corporation is right for you, or set yourself up to easily elect to be taxed as an s corp as your business growths and it becomes appropriate.
This guide also features links to more advanced s corporation concept guides.
Disclaimer: The information presented on this website is only a basic introduction to s corporation and partnership taxes. We strongly recommend that you hire a professional to help you. The information provided here does not replace the IRS instructions for filing taxes. Incorrect filings could lead to large tax bills and penalties. Please hire a CPA or an EA to prepare and file your tax returns.
S corporation quick summary
Small business owners that qualify may elect this status for tax treatment that tends to provide tax advantages, especially for closely held business that earn between about $40,00 and $400,000 in net profit each year.
One main advantage of an s corporation over a traditional “c” corporation is that most net profit “passes through” to its shareholders, rather than having it taxed twice.
Other advantages include potential savings on self employment tax, lower historic audit rates, multiple shareholder/ownership management, and less tax due from a disallowance in an audit.
An s corp is not right for everyone because there are some restrictions on who qualifies for the election and there is often the burden and expense of running payroll. This is because owners who actively participate in the business activities must be paid a reasonable salary.
Disadvantages include the monetary and time costs of running payroll, somewhat large penalties for all-around non-compliance, and the cost of filing federal and state corporate income tax returns. There is also the responsibility to get income and expense information out to the shareholders through Schedule K1. These burdens can create unnecessary risks for start-up companies with little working capital.
Also, because of the requirement to run payroll for owners who provide more than minor services, the s corp election may not be right for everyone. Running payroll involves strict tax depositing and tax return filing requirements. Non compliance with these requirements could even be considered criminal.
In general, it’s often best for start-up small businesses to set themselves up with a flexible entity that starts as a sole proprietorship for tax purposes, but then can easily elect s corporation taxation when the tax advantages outweigh the costs.
What is an s corporation?
Perhaps the most significant characteristic of s corporations is that the income and expense characteristics pass-though to it’s shareholders rather than being taxed at the corporate level.
An S Corporation is not really an entity per se, but an election to have an entity taxed under certain rules. These rules are found in Sub-chapter S of Chapter 1 of the Internal Revenue Code and thus the name s corporation caught on. Certain entities can elect to be taxed as an s corporation.
To elect s corporation taxation for your business entity, you must file form 2553. There are deadlines associated with this election for the tax year.
We strongly recommend that you consult with an experienced tax professional before you do this.
Who qualifies for the s corporation election?
To qualify for s corp taxation, for starters, the entity must be a US entity.
Also, the shareholders of an s corp must be individuals (and trusts, in some cases). They can’t be other corporations or partnerships.
The election qualifications also require that the s corp only has one class of stock, and there cannot be more than 100 shareholders.
Finally, you must not be what the IRS calls an “ineligible corporation”, which includes certain financial institutions, insurance companies, and domestic international sales corporations.
Generally, if you meet all of these requirements, then you can elect s corporation taxation for your business entity.
How to start an s corporation
To set up or start an s corp, first you must form an entity – this is usually filed with the appropriate state.
You will then need a tax identification for your s corporation, also known as an FEIN or federal employers identification number.
From there you can elect s corp taxation for your entity. Be sure to do this within the allotted time frame, as there are deadlines involved with making the election.
You will need a business bank account, and form there you can start running payroll, as required.
You also might need some sort of state license or registration depending on the business purpose and the laws of your state.
Employment taxes and s corporations
This part is important.
Shareholders of s corporations that perform more than minimal services for their business must run payroll and pay themselves a reasonable salary as an employee.
Running payroll includes payroll processing, payroll tax deposits, paying unemployment tax (in most cases), and the filing of payroll tax returns. In some states, workers compensation and/or temporary disability insurance may be required.
According to the IRS, this is true even for shareholders. What they are really after here is social security and Medicare taxes. After all, if you are providing services for a business – you should be paying these taxes and participating in the social security program.
Here’s where everyone screws up.
One thing that we see as tax preparers, is that s corporation owners will bypass running payroll and completely avoid these taxes. This is a huge mistake, and it most often results in a multi-year disallowance which comes with a large tax bill along with penalties.
It’s a trap.
Precedence has been set, many times in court, that the s corporation must pay it’s labor providers a salary and that it must also be reasonable.
Still, an s corporation shareholder/employee may see reduced employment taxes by operating as an s corp as compared to being a sole proprietor. Sole proprietors pay “self employment tax” on all of their business income up to a certain level. This often makes paying these taxes on a “reasonable” amount of salary better than paying them on ALL of their net profit.
S corporation tax return due dates, extensions, and late penalties
S corporation tax returns (form 1120s) are generally due on the 15 day of the third month after the end of it’s tax year.
So tax returns for s corps on a calendar year are mostly due on the 15th of March.
Tip: If an s corporation terminates and files a short year return, it must file within that timeline after it terminates. Waiting until March in the following year will invoke some nasty penalties.
Speaking of penalties, we have seen the IRS impose penalties of $195 per shareholder, PER MONTH (up to 12 months) for being late. So an s corporation with 4 shareholders that files a year late is subject to $9360 in late filing penalties, regardless of its income.
S corporations can file form 7004 to receive an automatic 6-month extension to file. Keep in mind that this extension does not give the shareholders additional time to pay any tax balance that may be due as a result of income that passes through to them. These amounts must be estimated and paid by the 15th of April, generally.
Pass-through characteristics and Schedule K1
When an s corporation has income (and other pertinent items), it generally does not pay any tax. All activity passes through to its shareholders.
For example, a food truck business has three partners. Partner A has a 50% share, partners B and C each have a 25% share. The business earned $100,000 in net profit (after all expenses).
Partner A is required to report $50,000 in ordinary business income, and partners B and C would report $25,000 each in ordinary business income.
There are many more “types” of income that an s corporation can realize, however, and there are many different tax rules for each type. These rules include tax rates, the way losses are treated, and certain limitation thresholds.
That’s where Schedule K1 comes in. The K1 is prepared along with the s corporation tax return and it summarizes all of these income characteristics. It is filed with the IRS and provided to each shareholder at tax time.
Here is part of the K1 form. Notice that in part 3 (on the right) there are many different categories to report.
If an s corporation contains rental property and an investment account, you might see box 2, 4, and 5 filled out. That way, these types of income will flow to the shareholders in a way that they maintain their tax characteristics. Box 5 b, qualified dividends, are almost always taxed at a lesser rate than other types of income. The K1 tracks the share of qualified dividends earned by the s corporation for each shareholder. If the info just came in one number, or just in box one, the individual would not get the appropriate tax benefit.
Schedule K1 helps s corporation shareholders work with certain thresholds, too.
Notice box 11 says “Section 129 deduction”. This is a part of the tax code that allows a business to expense an asset currently rather than capitalizing it and depreciating it over a few years. But there is a limit on how much asset value you can expense under section 179, and that limit is per individual, not per s corporation, so it is important to track how much of this expense was allocated to each shareholder.
S corporation tax preparation
Watch out for short-year deadlines.
Should you hire a professional to prepare your s corp taxes?
Well obviously as a tax professional I am biased, but I can honestly tell you that I see horror stories resulting form mistakes made by non-professionals on a regular basis. Self-preparers might think that they are saving money by going it alone, but in some cases it can REALLY cost them in the form of penalties and additional taxes. This doesn’t include the time-costs of self-preparation and fixing any problems as the IRS letters arrive.