s corporation

3 Key Benefits of an S Corporation Election

The deadline for S Corporations to file their annual tax returns is March 15, which means businesses with an S Corp election need to file Form 1120S and Schedule K-1. These forms, respectively, outline the financial activity of the S Corp in the last calendar year and detail the share of income, deductions and credits from the S Corp’s partners.

But, what if your current entity formation is a sole proprietor and you are considering an S Corp election? The good news is, you can start looking into filing for S Corp status this year.

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Here are some of the key benefits that come with choosing an S Corporation election:

Pass-through taxes

An S Corporation is a corporation with a pass-through entity. This means, according to the IRS, that an S Corp may elect to pass corporate income, losses, deductions and credits through to its shareholders for federal tax purposes.

How do pass-through taxes work?

Shareholders report taxable activity of the company on their personal income tax returns. Doing this means S Corporations do not pay federal and state income tax. As a result, S Corporations are able to legally avoid double taxation.

Keep in mind that other entities besides sole proprietors can benefit from pass-through entity status. Another formation that has pass-through entity status is a limited liability company (LLC). However, LLCs are not taxed as S Corps. LLCs are typically taxed as a default sole proprietorship or partnership status. If an LLC would like to be taxed as an S Corporation, they need to alert the IRS about how to treat their business for tax purposes. This means the LLC will need to qualify for S Corp status and file for an S Corp election.

Reducing self-employment tax liabilities

If you are incorporated as a sole proprietor, you are responsible for reporting all income on your tax returns. This includes self-employment tax and tax on all business profits. Sole proprietors must pay personal and business tax on their income — which often amounts to an expensive amount of taxes.

However, filing an S Corp election can help reduce these self-employment tax liabilities. Shareholders within an S Corp are given the opportunity to act as employees. These shareholders, now employees, receive a salary and dividends. They may draw a salary from the business profits with taxes taken directly out of their paychecks. The S Corp pays for half of the FICA payroll taxes throughout the year. Writing off these salaries helps shareholders reduce self-employment taxes and the total annual tax liability.

Limited liability protection

Finally, an S Corporation provides small businesses with limited liability protection. Sole proprietors may not be familiar with this term since there is no limited liability associated with the entity.

Let’s quickly define this term. Limited liability creates a separation between assets belonging to the business and the business owner. Entity formations with limited liability protection, including LLCs and corporations, separate professional and personal assets. Limited liability ensures that the personal belongings of the entrepreneur, like their house and car, for example, are not negatively impacted in the event of an unforeseen circumstance that impacts the business.

What happens if a business does not have limited liability? The responsibility for everything good and bad impacting the company falls on the owner. Many sole proprietors gain peace of mind in having their business protected by limited liability. As such, they may choose to elect an S Corporation that provides this liability protection to their business.

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Ready to form an S Corp election?

As mentioned earlier, a business that wishes to elect this filing must first qualify for an S Corporation.

Here are a few of the eligibility requirements for S Corps:

  • The business must be a domestic corporation
  • A registered agent must be designated for the company
  • The business may not have more than 100 shareholders
  • Shareholders must be individual persons
  • The business must have a single class of stock
  • The business may not be an ineligible corporation. These ineligible corporations include certain financial institutions, insurance companies and domestic international sales corporations

If your company is eligible for an S Corporation after reviewing these guidelines, file for S Corporation status using Form 2553. And remember, after you’ve filed as an S Corp, keep March 15 top of mind each year. This is your S Corp’s deadline for its tax return that must be filed on an annual basis.  

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