An S Corporation (S Corp) is a tax status that allows business income, losses, deductions, and credits to pass through to its shareholders for federal tax purposes. This structure can provide significant tax benefits, such as payroll tax savings. S Corporations are also a great way to avoid double taxation. If you want to learn more about the pros and cons of becoming an S Corporation, please read this [article – write the article]. Below is a comprehensive guide on how to become an S Corporation, whether you’re starting a new business or upgrading an existing business.
Step 1: Make Sure You Are Eligible for S Corporation Status
- Must be a corporation or LLC started in the U.S.
- Generally, all owners must be U.S. individuals – the company can’t have an owner that is an LLC, partnership, corporation, or foreign individual. Also permitted are estates, some trusts, tax-exempt organizations, and some disregarded LLCs, but check with a tax accountant first in these situations.
- Must have no more than 100 shareholders.
- Must only have one class of stock. This means that you must treat all owners equally (or proportionate to their percentage of ownership) in terms of the way income and distributions are split up.
Step 2: Make Sure It’s Actually a Good Idea to Be an S Corp
If you haven’t run the numbers on whether it’s a good idea for your business to be an S Corp, it’s important to work on this step before proceeding further.
While S Corps can often provide some tax savings, this is not always the case. Sometimes an S Corp will actually increase your overall tax burden. This can be related to how the deduction for Qualified Business Income (QBI) is calculated. In addition, business owners who also have a W-2 job elsewhere may pay more tax with an S Corp if their total earnings exceed the Social Security wage base.
Bearden, Stroup & Associates offers a free, no-obligation S Corp analysis to any business that is looking at what their optimal tax status should be. Click here for an easy questionnaire that we can use to analyze your situation.
Step 3: Form a Legal Business Entity
If you’ve already got an LLC or corporation, you can skip this step. But if you’re launching a new business or you’ve just been a self-employed sole proprietor (without an LLC), you’ll have to start an LLC or corporation.
- Form a Corporation (Inc.) or a Limited Liability Company (LLC) in the state where you’ll operate. File the appropriate formation documents with your state’s Secretary of State.
- We typically recommend an LLC, because this gives you more flexibility later if things change and you no longer want to be taxed as an S corporation.
- Apply for an Employer Identification Number (EIN) with the IRS. This is required to identify your business for federal tax purposes.
- Transfer your business assets (except real estate) into the name of the new entity. For example, if you already have a business bank account set up under your name, you’ll need to close that and open an account for your LLC.
- Use the new entity’s name in all contracts and official paperwork. For example, you may need to fill out a new Form W-9 for your business customers, and you need to make sure your credit card processing is set up properly using the new LLC’s name and EIN.
Step 4: File the Election with the IRS
Your LLC or corporation must file a form with the IRS to actually elect to be taxed as an S corporation.
- File Form 2553, “Election by a Small Business Corporation.”
- The form must be signed by all owners, as well as by an officer of the company (which in the case of an LLC would be a member or a manager).
- Mail or fax the signed Form 2553 to the IRS.
- Deadline for filing:
- If you just formed a new LLC or corporation, you’ve got 75 days to get Form 2553 filed if you want the S Corp status to be effective immediately. Having it effective immediately is often good because it makes you not subject to the 5-year rule where you have to keep your S Corp status for 5 years. However, some new businesses aren’t profitable enough to make the S Corp status worth it (see Step 2), so you may want to wait and make the S Corp status effective in a later year (see next bullet point).
- If you’ve already got an LLC or corporation, you can file Form 2553 at any time and make the election effective retroactive to any time within the past 75 days. However, consider making the election effective January 1 to simplify tax filing. In that case, you would need to file Form 2553 by March 15. If your existing corporation has a fiscal year, you’ll also generally need to file Form 1128 to change to a calendar year before the S Corp status can be effective.
Step 5: Start Paying Yourself W-2 Wages
Your S Corporation must pay you reasonable compensation for the work you do in the business. You’ll have payroll taxes withheld, and you’ll get a Form W-2 at the end of the year, just like any other employee. If you already have other employees, congrats: You just hired a new employee (yourself). Just add yourself to payroll like any other new hire. If you haven’t had any employees in the past, you will need to set up payroll accounts and processing.
Step 6: Start Filing S Corporation Income Tax Returns
Your S corporation will need to file its own 1120S income tax return, although generally the tax is paid by the owners. You will receive a Schedule K-1 showing the amount of income you must pay tax on, which must be included on your individual income tax return, along with your Form W-2 wages. You will also generally need to attach Form 7203 to your income tax return to track your basis and to calculate whether you have any taxable distributions or disallowed deductions.
Conclusion
Becoming an S Corporation can offer significant benefits, such as tax savings and limited liability, but it’s essential to approach the process with careful planning. By ensuring your business meets eligibility requirements, analyzing whether S Corporation status aligns with your financial goals, and following the necessary legal and tax steps, you can set your business up for success. Remember, the decision to become an S Corporation isn’t one-size-fits-all. Consulting with a tax professional or accountant can help you make an informed choice and avoid potential pitfalls.
If you’d like professional assistance with becoming an S Corporation, schedule a meeting with our accountants today. With the right guidance and preparation, transitioning to an S Corporation can be a smart move for your business’s financial future.