Corporate Governance
What is an S-Corp Election, When Do I File, and Why Do I Need It?
By Chris N. Tzortzis · Published · Updated
For many small business owners, navigating tax elections can feel overwhelming. One of the most common decisions business owners face is whether to elect S-Corp status for their company. But what does that mean, when should you do it, and why might it be beneficial? Let’s break it down in simple terms.
What is an S-Corp Election?
An S-Corp election is a tax classification, not a business structure. Your business can be an LLC or a corporation, but choosing S-Corp status means you’re electing to be taxed under special rules outlined by the IRS. This election allows your business to avoid double taxation, which is common for traditional corporations (C-Corps), while also offering potential tax savings on self-employment taxes.
When Should You Consider an S-Corp Election?
The IRS generally requires Form 2553 to be filed no more than two months and 15 days after the beginning of the tax year for which the election is to take effect, or at any time during the preceding tax year. This is a calendar-month rule, not a fixed 75-day deadline.
New business: Determine when the entity’s first tax year begins rather than automatically counting from the state formation date. The Form 2553 instructions explain the start-date rules and provide examples.
Existing calendar-year business: The usual deadline is March 15 for an election effective January 1 of that year. Different tax-year start dates produce different deadlines; weekend and legal-holiday rules can also affect the filing date.
Missed deadline: Do not assume you must wait until the following year. Late-election relief may be available under Revenue Procedure 2013-30, generally within three years and 75 days of the intended effective date if all applicable conditions are met. Those conditions include reasonable cause, diligent correction, and consistent tax reporting. Limited exceptions also exist; consult a tax professional about eligibility and the required filing.
When Profits Grow:
Consistent profits may make an S-Corp election worth evaluating, but there is no universal profit threshold. Potential savings depend on reasonable compensation, payroll and accounting costs, state taxes, and your circumstances. Review the numbers with a qualified tax professional before electing.
Why Would You Want an S-Corp Election?
The biggest reason to elect S-Corp status is to reduce self-employment taxes, but there are a few other benefits as well:
1. Save on Self-Employment Taxes and Payroll Tax Planning
Sole proprietors and many LLC owners taxed as partners generally pay self-employment tax on net earnings, subject to applicable limits and exceptions. An S-Corp shareholder who provides services must receive reasonable compensation before taking non-wage distributions. That salary is paid as W-2 wages subject to employment taxes, including Social Security and Medicare—not self-employment tax. Properly characterized non-wage distributions generally are not subject to employment or self-employment tax, but S-Corp income remains subject to applicable income taxes.
2. Pass-Through Tax Treatment
S-Corp income and losses generally pass through to shareholders for federal income-tax purposes. This generally avoids the corporate-level income tax and dividend-level tax associated with a C-Corp, although certain entity-level taxes can still apply.
3. Ownership Planning
An S-Corp election does not change an LLC into a corporation or automatically make ownership transfers easier. Transfers must comply with the entity’s governing documents, state law, and S-Corp shareholder-eligibility rules.
Are There Any Downsides?
While S-Corp status has clear advantages, there are also some limitations to keep in mind:
A shareholder-employee who provides services must receive reasonable compensation before non-wage distributions. The IRS can reclassify distributions as wages when compensation is inadequate, resulting in additional employment taxes and possible penalties.
More paperwork and compliance. You’ll need payroll filings and an S-Corp tax return, along with records and formalities appropriate to your underlying LLC or corporation. The tax election alone does not impose identical corporate meeting requirements on every LLC.
Restricted shareholders. An S-Corp generally cannot have more than 100 shareholders. Eligible owners include individuals, certain trusts, and estates; partnerships, corporations, and nonresident alien shareholders generally are not eligible, subject to limited statutory exceptions.
Only one class of stock. Shares must generally have identical rights to distributions and liquidation proceeds. Differences in voting rights are permitted and do not, by themselves, violate this rule.
How to Elect S-Corp StatusIf you decide an S-Corp election is right for your business, here’s how to do it:
Form a Business Entity – You must have an LLC or Corporation already in place.
File IRS Form 2553 – Obtain the required shareholder consents and submit the election by the applicable tax-year-based deadline described above. Coordinate any state-level election requirements with your tax professional.
Set Up Payroll – Since you’ll need to pay yourself a reasonable salary, you’ll need to establish a payroll system.
Maintain Compliance – Keep up with required filings, tax returns, and corporate formalities.
Final Thoughts: Is an S-Corp Right for You?
If your business is earning enough to make tax savings worthwhile and you’re comfortable handling payroll and compliance requirements, an S-Corp election can be a smart move. However, if your business is still in its early stages or has low profits, sticking with an LLC or sole proprietorship might be simpler and more cost-effective.
Need help deciding? At Auxo Law, we specialize in helping small business owners make informed legal and financial decisions. If you're considering an S-Corp election and want to discuss the pros and cons for your specific situation, reach out today!
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Sources
This article is general information, not legal advice, and reflects the law as of its last updated date. Rules differ between New York and Colorado. For advice about your situation, schedule a consultation.
