S Corporation

An S corporation is a corporation, or an entity electing to be treated as one, that has made a valid election under IRC 1362(a) to be taxed under subchapter S. IRC 1361(a)(1) puts it plainly: the term means "a small business corporation for which an election under section 1362(a) is in effect for such year." Income, deductions, and credits pass through to the shareholders and are reported on their personal returns, so the profit is generally taxed once rather than twice. In running text both the IRS and the U.S. Code write it "S corporation" with a lowercase c, and the statutory eligibility term is "small business corporation," which is what Form 2553 is titled after.

The category error worth correcting first is that an S corporation is not an alternative to an LLC. An LLC is created under a state statute and defines what the business legally is. An S corporation is a federal tax classification and defines how the business is taxed. A business can be both at once, and many are. Under 26 CFR 301.7701-3(c)(1)(v)(C), an eligible entity that timely elects S corporation status "is treated as having made an election under this section to be classified as an association," which means an LLC making the election files Form 2553 alone and does not have to file Form 8832 first.

What the election actually changes for a working owner is the character of their own earnings. A sole proprietor or a partner in an operating partnership pays self-employment tax on essentially all of the business's net earnings. An S corporation owner who works in the business is an employee of it, is paid a wage subject to Social Security and Medicare tax through payroll, and may take the remaining profit as a distribution that is not subject to those taxes. Income tax applies to the whole of it either way; the saving is confined to the payroll tax side.

That saving is bounded in two directions that the standard pitch for the election leaves out. The wage has to be reasonable compensation for the work actually performed, and this is a well-worn area of IRS examination and litigation, so setting the wage implausibly low is not a strategy but a risk. And the election buys real administrative cost: a separate Form 1120-S with Schedules K-1, quarterly employment tax returns, an annual federal unemployment return, payroll processing, and in many states a separate state filing. Below some level of profit those costs consume the saving entirely.

The "no corporate tax" shorthand is also imprecise. The IRS states directly that "S corporations are responsible for tax on certain built-in gains and passive income at the entity level." The built-in gains tax matters most to a C corporation that converts, and the passive income tax to an S corporation with substantial investment income and accumulated earnings from C years. Neither applies to a typical service business that has always been an S corporation, which is why the simplification survives.

Eligibility comes first. IRC 1361(b) defines a "small business corporation," and the IRS lists the requirements as: be a domestic corporation; have only allowable shareholders, which may be individuals, certain trusts and estates but may not be partnerships, corporations or non-resident aliens; have no more than 100 shareholders; have only one class of stock; and not be an ineligible corporation. The statutory list of ineligible corporations is narrower than most readers expect, reaching a financial institution using the bad-debt reserve method, an insurance company taxed under subchapter L, and a domestic international sales corporation.

The election is made on Form 2553, "Election by a Small Business Corporation." Timing is statutory: under IRC 1362(b), an election made no later than 2 months and 15 days after the first day of the tax year is treated as timely for that year, and an election filed after that generally takes effect the following year. Relief for a late election is available where there was reasonable cause. All shareholders must consent.

Once the election is in place, the filings change:

• The corporation files Form 1120-S and issues each shareholder a Schedule K-1 reporting their share of income, deductions and credits.
• An owner who works in the business is an employee, so the corporation files employment tax returns and an annual federal unemployment tax return, and issues the owner a Form W-2.
• The shareholder reports the K-1 amounts on their personal return and pays income tax on their share of profit whether or not it was distributed.

A hypothetical, resolving what the election changes rather than an amount. Ravi's consulting LLC nets $150,000 in profit and he works in it full time. As a disregarded single-member LLC, essentially all of that net profit is subject to self-employment tax. If he elects S corporation treatment and the corporation pays him a reasonable wage for the consulting work he performs, only the wage bears Social Security and Medicare tax, and the profit above it passes through as a distribution that does not. His income tax is unaffected: the wage and the distribution are both taxed to him as ordinary income. Against the payroll tax saved he has to set the cost of running payroll, the Form 1120-S and its schedules, any state-level S corporation filing, and the burden of being able to defend the wage as reasonable if asked.

Getting out again is not free either. Under IRC 1362(g), a corporation whose election has been terminated generally may not elect again before its fifth taxable year after the termination year without the Secretary's consent, so the election should be treated as a multi-year decision rather than an annual one.

Pros

• Profit is generally taxed once, at the shareholder level, rather than at the entity level and again on distribution.
• The wage-and-distribution split can reduce Social Security and Medicare tax on a working owner's earnings.
• Available to an LLC as well as a corporation, so a business can keep the simpler state-law form and still get the tax treatment.
• Losses generally pass through to shareholders, subject to basis and other limits, which can be useful in early years.

Cons

• Real and recurring administrative cost: payroll, employment tax returns, Form 1120-S, and often a separate state filing.
• Reasonable compensation is a genuine exposure, not a formality, and the saving shrinks as the wage rises to a defensible level.
• Eligibility is restrictive. One class of stock rules out many financing structures, and partnerships and corporations cannot be shareholders.
• Not free of entity-level tax. Built-in gains and excess passive income can be taxed to the corporation.
• A terminated election generally cannot be remade for five years without IRS consent.