As your small business or startup continues to grow and expand, you may be interested in exploring what an S Corp election could provide.
What is an S Corp?
An S-Corporation is an elected tax status, unlike an LLC which is a business entity. In an LLC, members must pay self-employment taxes, which are Social Security and Medicare taxes, directly to the IRS.
Why elect to be an S Corp?
As the income from an LLC increases, so do the self-employment taxes. If an eligible entity converts to an S Corp they can avoid double taxation that can occur in a corporate structure due to this election as long as the officers of the corporation are paid a “reasonable salary”.
The entity will be responsible for paying the employees their wages, while the remaining profits will be distributed to the shareholders as dividends. The dividends will be taxed at a lower tax rate than ordinary income.
Businesses can elect to be an S Corp by utilizing Form 2553.
What is a Reasonable Salary?
S-Corp’s are required to take a reasonable salary under IRS’s reasonable compensation regulations.
The Balance describes the following factors recommended by the IRS to determine a reasonable salary for an officer of an S Corp -
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
S Corp Eligibility
Brex details the necessary requirements to be eligible for an s corporation election
- Be a Domestic Corporation
- Have Only Allowable Shareholders - Shareholders can not consist of partnerships, corporations, non-resident aliens
- Have no more than 100 Shareholders
- Have only one class of stock
- Be an eligible business type - Financial institutions, Insurance Companies, and Sales Corporations are not allowed to form an S Corporation
S Corp Pros
- The ability to divide personal income and dividend income
- The business pays your salary and the payroll taxes on it, versus having to pay self-employment taxes on your personal return with an LLC
S Corp Cons
- Reasonable Salary Compensation Must be Established
- Limit to One Class of Stock and Maximum of 100 Shareholders
- Shareholders own more than 2% of the company's stock and can't claim employee health insurance as a tax-free benefit as they could with a C-corp.
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