S-Corp Tax Elections - Choice of Entity is only Part of the Equation
Article by David Hill
When you start a business, one of the first questions usually relates to whether you need to form a legal entity and, if so, which type of entity. This discussion then usually devolves to a review of the pros and cons of limited liability companies (LLC) and corporations. Most small businesses select an LLC as the most appropriate type of entity. Many business owners often do not immediately understand the second question that they should ask themselves – what "tax election" should they make? After you choose the entity type, the tax election identifies how the IRS will tax your company. This process, known as the check the box election, allows you to select the type of taxation (using the SS-4 tax form).
The common tax elections include as a disregarded entity, partnership or as an s-corporation. A common misnomer relates to taxation as an s-corporation. Many believe that you must form your company as a corporation to receive the benefit of s-corp taxation. In fact, you can obtain the benefit of s-corp taxation even if you form your company as an LLC. This allows you to obtain the best of both worlds - the simplicity of an LLC with the tax benefits of an s-corp.
A primary benefit of s-corp taxation allows you to, under certain circumstances, avoid self-employment tax on a portion of the income generated by the company. Self-employment tax will attach to the wages paid but you can characterize all income above and beyond wages as a distribution not subject to self-employment tax. Depending on the income generated by the company, this could result in significant savings.
To qualify for an s-corp election, your company must meet various IRS requirements, including limitations which restrict the company to one class of ownership, not more than 100 owners, and no ownership by certain other types of entities. These rules are multifaceted and certain exceptions apply to the general prohibitions (e.g. single member disregarded entities are still permissible owners of an s-corp). If you elect s-corporation status, you must also ensure that your operating agreement reflects these requirements – complexities also arise in this area. For example, if you treat members differently within the operating agreement, the IRS could interpret this as more than one class of ownership even if the operating agreement only designates one ownership class.
If your business currently generates income that exceeds what would equate to a reasonable wage for your services, you should consider the possible benefits of changing your tax election. We start that analysis by reviewing your financial position, operating agreement, and related information about your business. For more information on whether you might qualify for s-corporation taxation, please contact a member of our Business Practice Group.