Making an S-Election

Navigating the S-Corp Decision

As a tax advisor, I often find myself immersed in conversations with business owners contemplating the shift to S-Corporation status. This decision is not to be taken lightly, as it involves a thorough analysis of the pros and cons, eligibility criteria, and the ongoing commitment to remain compliant with IRS guidelines. Let's delve into the intricacies of making an S-election, exploring both the advantages and challenges inherent in this tax structure.

Wait... what's an S-Corp and what's the big deal?

Contrary to most people's understanding an S-Corp is not a business entity type. Rather it is an election of S-Corp tax treatment for either an LLC or a corporation. This means that either an LLC or corporation must be formed in order to make this election; however, this election isn't necessarily the most tax-advantaged scenario for everyone. 

Ultimately this allows for a portion of your business income to be subject to income tax, but not self-employment taxes, saving the business owner about 15% of the income excluded from the reasonable compensation requirement. Before taking on the additional cost and administrative responsibilities associated with making the election I always recommend speaking with a tax professional, but a good rule of thumb is that you should be making $50-60K in profit before making the election and a consistently positive cash-flow.

If you pass that quick test keep reading to learn more about the advantages of making an S-Election and what it takes to remain compliant.

The Pros:

Pass-Through Taxation: One of the primary attractions of S-Corporations is pass-through taxation. Unlike C-Corporations, S-Corps themselves are not subject to federal income tax. Instead, profits and losses are passed through to shareholders, who report this income on their individual tax returns. This often results in a lower overall tax liability for the business.

Limited Liability Protection: Similar to C-Corporations, S-Corporations offer limited liability protection to their shareholders. This means that the personal assets of shareholders are generally protected from business debts and liabilities.

Flexibility in Allocations: S-Corporations provide flexibility in allocating income and losses among shareholders. This can be advantageous in tailoring the distribution of profits to match the varying needs and tax situations of individual shareholders.

Avoidance of Double Taxation: S-Corporations avoid the double taxation that C-Corporations face. This means that income is not taxed at both the corporate level and the individual level, as is the case with C-Corporations.

The Cons:

Restrictions on Ownership: S-Corporations have restrictions on ownership. They cannot have more than 100 shareholders, and these must be individuals, certain trusts, and estates. Additionally, non-resident aliens are generally ineligible to be shareholders.

Limited Capital Structure: S-Corps are restricted in their capital structure. They can only issue one class of stock, limiting the ability to attract different types of investors.

Potential Loss of Deductions: Losses in excess of a shareholder's basis are not deductible and may be carried forward. This limitation could impact the ability to use business losses to offset other income.

Ongoing Compliance Requirements: S-Corporations must adhere to strict compliance requirements set forth by the IRS. Failure to meet these requirements can lead to the revocation of S-Corporation status.

Eligibility and Requirements:

Eligibility Criteria: To qualify for S-Corporation status, a business must be a domestic corporation, have only allowable shareholders (individuals, certain trusts, and estates), not have more than 100 shareholders, and have only one class of stock.

Election Process: A business elects S-Corporation status by filing Form 2553 with the IRS. This election must be made by the 15th day of the third month of the tax year for which the election is intended to be effective.

Additional Costs and Compliance:

Professional Fees: Engaging a tax professional is crucial for S-Corporations. The complexity of tax regulations requires expert guidance, and this incurs additional professional fees. These fees vary from provider to provider as well as on the services you're engaging them for. As a reference point, while outsourcing bookkeeping and accounting at Musing Sally is billed at $50/hour, consultations range from $150-$250 depending on to topic of the consultation. Some clients also opt to establish a monthly retainer to cover sever

$50-250/hour

Payroll Processor Expenses: Many S-Corporations choose to utilize payroll processors to handle the intricacies of payroll management, including calculating and disbursing employee salaries, managing tax withholdings, and ensuring compliance with employment regulations. While this streamlines the payroll process, it comes with associated costs.

Starting at $50/month

Record-Keeping Requirements: S-Corporations must maintain accurate records of income, expenses, and other financial transactions. Good record-keeping is not just a best practice; it's a necessity for compliance. This cost varies depending on whether you plan to continue doing it yourself, delegate it to an employee, or start outsourcing your bookkeeping to a bookkeeper or an accountant.

Starting at $250/month

Annual Filings: S-Corporations are required to file an annual tax return (Form 1120S) with the IRS. Additionally, shareholders receive a Schedule K-1, which details their share of income, deductions, and credits.

$650-$1000/year

Reasonable Compensation: Shareholder employees must receive reasonable compensation for their services. Determining what is "reasonable" can be subjective and may require careful consideration. Generally, this should be based on comparable salaries in the same industry, region, and position.

$45,000+/year

Employer Taxes: In addition to committing to paying your salary, you will also be liable to pay employment taxes on that salary. While the scenario in which we would make this election means you will end up spending you less on employment taxes than you would by paying self-employment taxes, it's important to be aware of what those taxes are. Keep in mind that you will also be responsible for the individual portion of the FICA taxes and any income tax you elect to have withheld from your paycheck.

Employer portion of FICA taxes - 7.65%

Federal Unemployment Insurance Tax - 6% on first $7,000

State Unemployment Insurance Tax - varies by state

The decision to elect S-Corporation status involves a careful weighing of the advantages and disadvantages, a thorough understanding of eligibility criteria, and a commitment to ongoing compliance. While the potential tax savings and flexibility can be significant, business owners must work closely with tax advisors to navigate the complexities of S-Corporation taxation successfully. The S-Corp journey is not without its challenges, but with strategic planning and diligent adherence to IRS guidelines, it can be a tax-efficient structure for many small and medium-sized businesses.

If you think your business is a good fit for an S-Election, book a 2-hour tax strategy consultation to review your tax scenario, make the election, and start the setup process to keep you compliant.