Death and taxes aren’t the only two things you can be sure of in life - because you can also be sure that taxes will be complicated.
Maybe even more complicated? Figuring out how to pay less in taxes (legally, of course!)
If you’re forming a corporation, you’ve probably heard of “S-corporations” and “C-corporations”, but what are they and how do you know which you should be? Startomatic is here with answers. Note: If you're forming an LLC, we have some good news for you: you are probably already going to get the tax benefit of "pass-through" taxation (more on that below). This post is focused on corporations - we'll address the rare case where LLCs may want to make an S-election in a later blog post, which we'll link here when it's up.
What’s an S-Election?
An “S-election” is when you tell the IRS that you want your corporation to be taxed as a sole proprietorship (if there is only one owner) or a partnership (if there are two or more owners). Corporations that make an S-election are called “S-corporations”. A “C-corporation” is simply a corporation that has not made an S-election.
In order to understand why you might want to be taxed as a sole proprietorship or partnership, you first need to understand “pass-through taxation” and its evil twin, so-called “double taxation”.
Pass-through taxation is when the company itself pays no federal income tax. Instead, the owner(s) of the company report the company's profits on their personal tax returns and pay the taxes directly. Partnerships and sole proprietorships - and LLCs - usually enjoy pass through taxation.
This is in contrast to the “double taxation” of a C-corporation. Here's how that works: the company pays federal taxes on its income, and then when it distributes earnings to the shareholders, the also pay federal tax on that money. Ok, so it's not actually "evil", but "double taxation" generally means the IRS collects more than it would from a company with pass-through taxation.
To sum up: C-corporations = “double taxation”, while S-corporations = “pass-through taxation”, and double taxation almost always means business owners pay more in taxes.
So… Why Doesn’t Everyone Choose the S-Corporation?
Well, the IRS likes collecting taxes, so of course they don’t make it that easy to pay less. S-corporations have some fairly significant limitations. In particular, S-corporations:
Can have no more than 100 shareholders
Can have only one class of stock (so no preferred stock, which is what outside or professional investors usually want)
Can only have shareholders who are individuals (so no companies can be shareholders, again meaning many investors are shut out)
All shareholders must be U.S. citizens or lawful permanent residents
You can see why many corporations are not able to make an S-election. But those limitations are generally applicable only to larger companies, and those that are seeking outside funding. Which leads us to the question:
Should You Make an S-Election?
Yes, if, like many new small businesses, you’re forming a corporation (as opposed to an LLC or other legal entity type), AND you meet all of the qualifications above (no more than 100 shareholders, all of whom are individual U.S. citizens or lawful permanent residents, and you don’t intend to issue preferred stock in the near term).
No,if you’re forming a corporation that does not meet all of the requirements above, OR you are planning to seek outside investment from professional investors (like sophisticated angel investors or venture capital funds) in the near term.
Pro Tip: you can change from an S-corporation back to a C-corporation in the future - you’ll just have to make a filing with the IRS (and of course there are a few restrictions).
OK, I Want to Make an S-Election - How Do I Do It?
Here’s some good news: it’s super easy to do. In fact, if you’re using Startomatic, we’ve built a Starter Tool that automates the whole process. And if you’re not using Startomatic (why wouldn’t you??), it’s still not that hard - you just have to file Form 2553 with the IRS. They even provide complete instructions here - just don’t expect them to be easy to read. This is the IRS we’re talking about, after all...
One important note: there are deadlines for filing your S-election. If you are a newly-formed corporation, you generally must file Form 2553 within about 75 days of your formation. An already-existing C-corporation must file their S-election on or before the 15th day of the third month of the year they want to be taxed as an S-corporation. (We told you it was complicated! For more on timely filing the S-election, check out the IRS information, here.
TL;DR: The absolute easiest way to file an S-election (IRS Form 2553) is with Startomatic’s S-Election Application Starter Tool.
Even MORE Complicated: LLCs and S-Elections
By default, limited liability companies (“LLCs”) have the benefit of pass-through taxation. But - like corporations - LLCs can make an S-election. Why would they want to do that? You guessed it… it’s complicated. So complicated in fact that we’re going to address it in a whole separate upcoming blog post - stay tuned!
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