This article will discuss the effect of an S-Corp Election for a small business. Two foundational articles that you may find helpful are:
A common preliminary question that business clients ask our Illinois business attorneys is, “should my business be an LLC or an S-Corporation?” The answer is that it can be both. When filing your incorporation documents with the secretary of state, you choose between being an LLC or a Corporation. Then, whether your business is an LLC or a Corporation, you can choose to file an S-Corp Election with the IRS. So, whether your business is a Corporation or an LLC at the Secretary of State level, you can choose to be taxed as an S-Corporation at the IRS Level.
What Does an S-Corp Election Do?
Pass-through Income Tax for Corporations
If you elect to form a Corporation at the Secretary of State level, you are by default a C-Corporation. Shareholders of a C-Corporation pay income tax twice: once at the corporate level on corporate income, and a second time on the personal level on the distributions they receive as shareholders. When a Corporation chooses to be taxed as an S-Corp rather than a C-Corporation the shareholders will only be taxed once. They will not pay taxes on the corporate level, but instead their corporate income will “pass through” to their personal taxed returns. The shareholders only pay taxes once, on their personal tax returns.
Savings on Self-Employment Tax for both LLCs and Corporations
LLCs, by default, have pass-through taxation. However, there is an additional benefit to the S-Corp Election that is shared by both LLCs and Corporations: savings on Self-Employment Tax. In addition to income tax, if you are self-employed or if you are employed by your Corporation or LLC without having filed an S-Corp election, you will have to pay self-employment tax on everything you take home from your business. If you are set up as a corporation or an LLC and you file an S-Corp election with the IRS, you can take a portion of your business income as a salary and the rest as profit. You will only pay self-employment tax on your salary, and will take your profits free and clear of self-employment tax! This means that even though it costs money to incorporate, incorporation will actually save you money in the long run by reducing your self-employment tax.
Is an S-Corp Election a Good Fit for My Company?
S-Corp’s are restricted both in who can own stock and in how profits can be distributed.
Ownership Restrictions
S-Corps are subject to the following ownership restrictions:
- There must be 100 or fewer shareholders;
- The shareholders must be residents of the United States; and
- Shareholders cannot be other LLCs or corporations.
- Restrictions on Distribution of Profits
All S-Corp profits must distributed based on the ratio of stock an owner holds in the corporation. For example:Al, Ben, and Charlie form ABC, Inc. as an S-Corporation. Al invests $10,000, while Ben and Charlie each invest $5,000. Al would have 50% ownership in the corporation with Ben and Charlie each having 25% ownership in the corporation. When profits are distributed, Al would receive half of all profits distributed, while Ben and Charlie would each receive a quarter of the profits.
In the case of an LLC that is not taxed as an S-Corp, the wishes of the owners, not the stock-ratio-system, determine how corporate profits are distributed. For example:
Al, Ben, and Charlie form ABC, LLC. Even if Al invests $10,000, while Ben and Charlie each invest $5,000 (as in the previous example), Al, Ben and Charlie could decide to distribute corporate profits according to each shareholder’s ownership percentage. Since ABC, LLC is an LLC and not an S-Corp, Al, Ben, and Charlie would be restricted to the stock-ratio distribution. For more information on how to maintain your s-corp read our article.
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