Sub Chapter S Election – Form 2553 To Save Your Business Money On Taxes
If your small business is or perhaps more importantly will be netting you over $50,000 this tax year and you’re operating your LLC as a disregarded entity, you may be paying too much in taxes.
One potential strategy on reducing your tax liability and keeping more of your hard earned money in your pocket is being smart about how your business operates. This includes for many, taking what’s known as a S corporation election.
I have provided a link at the bottom for the IRS form 2553.
Taking a S corporate election doesn’t mean changing your sole proprietorship or LLC business into a corporation, taking the election means the TAX TREATMENT of your business.
For those without an LLC or corporate entity, this means either forming an LLC or corporation (for most small businesses, an LLC is the superior choice and feel free to reach out to discuss why) to avail the tax advantages of being taxed as an S corporation.
For almost all small businesses operating as Limited Liability Companies (LLCs), the question of tax optimization often arises, especially during tax season.
While LLCs offer the appealing combination of limited liability protection and pass-through taxation, there exists a distinct entity called an “S corporation” that presents potentially significant tax advantages under certain circumstances.
However, navigating the intricacies of electing S corporation status requires careful consideration and understanding.
Let’s examine the basics. Including an outline of the many the benefits, drawbacks, and crucial steps involved in the process. Again, it’s important to note and highlight that we’re discussing the tax treatment available to most LLCs if it makes financial sense.
Understanding the Playing Field: LLCs vs. S Corporations
LLCs and LLC’s taking the S corporate election share some key features, including pass-through taxation, where business income and losses flow directly to the owners’ personal tax returns. However, significant differences exist in terms of tax treatment, ownership structure, and formalities.
LLC:
Taxation: LLCs are taxed as sole proprietorships or partnerships, depending on the number of owners.
Ownership: LLCs have no restrictions on the number or type of owners, including non-resident aliens and certain trusts.
Formalities: LLCs have less stringent administrative requirements than corporations, and when an LLC takes a S corporate election the formalities remain the same in most aspects.
S Corporation Election:
Taxation: S corporations also avoid double taxation by electing to be taxed similarly to partnerships. Shareholders pay taxes only on their individual tax returns based on their share of corporate income and losses.
Ownership: S corporations are limited to 100 shareholders who must be US citizens or resident aliens. Only one class of stock is allowed. For almost all small businesses, this isn’t a factor at all.
Weighing the Pros and Cons: Is an S Corp Election Right for You?
The decision to elect S corporation status should be based on a comprehensive analysis of your specific business situation and financial goals. Here’s a breakdown of the key advantages and disadvantages:
In Favor:
Avoidance of double taxation: This can be a significant benefit for businesses with high profits and active owners who wish to pay taxes at lower individual rates.
Potentially lower payroll taxes: S corporation owners classify themselves as employees and receive a salary, akin to a LLC, however, by taking the S corp election, the owner may be able to shift some income from earned income subject to Social Security and Medicare taxes to “investment income,” thereby reducing Social Security and Medicare taxes on a portion of their income.
For most business owners, this is the most significant and meaningful motivation to make the change.
Attractive to investors: S corporation status can be appealing to potential investors due to the pass-through taxation feature.
Lower Audit Risk: This is hard to quantify for any given business, and really shouldn’t be a heavily weighted factor, however, I don’t know anyone who wants to be audited by the government even when the books are perfect. At a minimum, it’s an uncomfortable distraction for the business owner.
Against:
Ownership restrictions: The 100-shareholder limit and citizenship/residency requirements can be limiting for some businesses. Again, for most, this doesn’t matter.
Increased administrative burden: S corporations require more formal recordkeeping and meetings, leading to additional costs and compliance obligations. If a LLC entity business takes the S corporation election, actual payroll must be performed (if the business already has employees, this is a minimal cost factor) and the business will file a separate tax return similar to a C corporation called a 1120s tax return, albeit the income continues to pass-through to the owner(s).
Potential for payroll tax issues: The classification of owners as employees can trigger complex payroll tax rules and potential IRS scrutiny.
Navigating the Maze: Taking an S Corporation Election for Your Small Business LLC
For many small businesses operating as Limited Liability Companies (LLCs), the question of tax optimization often arises.
While LLCs offer the appealing combination of limited liability protection and pass-through taxation, there exists a distinct entity called an S corporation that presents potentially significant tax advantages under certain circumstances.
However, navigating the intricacies of electing S corporation status requires careful consideration and understanding. This article delves into the essential aspects of making an S corporation election for your small business LLC, outlining the benefits, drawbacks, and crucial steps involved in the process.
Understanding the Playing Field: LLCs vs. S Corporations
LLCs and S corporations share some key features, including pass-through taxation, where business income and losses flow directly to the owners’ personal tax returns. However, significant differences exist in terms of tax treatment, ownership structure, and formalities.
LLC:
Taxation: LLCs are taxed as sole proprietorships or partnerships, depending on the number of owners.
Ownership: LLCs have no restrictions on the number or type of owners, including non-resident aliens and certain trusts.
Formalities: LLCs have less stringent administrative requirements than corporations.
S Corporation:
Taxation: S corporations avoid double taxation by electing to be taxed similarly to partnerships. Shareholders pay taxes only on their individual tax returns based on their share of corporate income and losses.
Ownership: S corporations are limited to 100 shareholders who must be US citizens or resident aliens. Only one class of stock is allowed.
Formalities: S corporations have stricter administrative requirements, including annual meetings, board of directors, and formal recordkeeping.
Weighing the Pros and Cons: Is an S Corp Election Right for You?
The decision to elect S corporation status should be based on a comprehensive analysis of your specific business situation and financial goals. Here’s a breakdown of the key advantages and disadvantages:
Advantages:
Avoidance of double taxation: This can be a significant benefit for businesses with high profits and active owners who wish to pay taxes at lower individual rates.
Potentially lower payroll taxes: S corporation owners can classify themselves as employees and receive a salary, thereby reducing Social Security and Medicare taxes on a portion of their income.
Attractive to investors: S corporation status can be appealing to potential investors due to the pass-through taxation feature.
Disadvantages:
Ownership restrictions: The 100-shareholder limit and citizenship/residency requirements can be limiting for some businesses.
Increased administrative burden: S corporations require more formal recordkeeping and meetings, leading to additional costs and compliance obligations.
Potential for payroll tax issues: The classification of owners as employees can trigger complex payroll tax rules and potential IRS scrutiny.
Taking the Plunge: The Election Process Explained
If, after careful consideration with your tax professional, you decide to pursue S corporation status, here’s a step-by-step guide to the election process:
Eligibility Check: Ensure your LLC meets all S corporation requirements, including number and type of owners, US citizenship/residency, and single class of stock.
Shareholder Consent: Obtain written consent from all existing shareholders agreeing to the election. This is sometimes skipped accidentally when a husband and wife both own the LLC. When there is more than one owner, including a spouse, ALL owners need to sign and approve.
Form 2553: File IRS Form 2553 and return to the IRS by the due date of your corporate tax return (including extensions) for the year you wish the election to be effective. This generally means March 15th of each year. While there can be reasons to justify a late 2553 filing, it’s best if done prior to March 15 for payroll reasons.
State Filings: Depending on your state, you may need to file additional forms or notify state authorities of the election.
Should your business take the election? That really depends on a few factors and as stated near the top, generally, a business may benefit if the net earned income is over $50,000, however, there’s a large grey area that can be considered with income as low as $40,000 a year too. And as you may imagine, as the income increases from $40,000 towards $50,000 the case becomes stronger.
Electing S Corporation status for an LLC can offer meaningful tax savings and benefits for small business owners. However, it’s essential to approach this decision with a comprehensive understanding of both the advantages and the potential complexities involved which means for most a conversation with a tax advisor who can lay out the pros and cons to make sure you’re making an informed decision.