S-Corporation election

An S-Corporation (S-Corp) is not a type of business entity — it is a tax election. An existing LLC or corporation files IRS Form 2553 to elect S-Corp tax treatment, which allows the business to split income between salary (subject to payroll taxes) and distributions (not subject to self-employment tax).

42 steps across 11 sections

1. Default Tax Treatment (Without S-Corp Election)

  • Single-member LLC: Taxed as sole proprietorship (Schedule C). All net income is subject to 15.3% self-employment tax.
  • Multi-member LLC: Taxed as partnership (Form 1065). Each member's share of income is subject to self-employment tax.
  • Corporation: Taxed as C-Corp (double taxation on dividends).

2. With S-Corp Election

  • Business income passes through to owners' personal tax returns (no entity-level federal tax)
  • Owner-employees must pay themselves a reasonable salary (subject to payroll taxes)
  • Remaining profits are distributed as dividends/distributions (not subject to self-employment tax)
  • Only the salary portion is subject to FICA taxes (Social Security 6.2% + Medicare 1.45% = 7.65%, matched by the business for total 15.3%)

3. Eligibility Requirements

  • Domestic entity — formed in the United States
  • 100 or fewer shareholders (members)
  • Only allowable shareholders — individuals, certain trusts, and estates (no corporations, partnerships, or non-resident aliens)
  • One class of stock — all shares must have identical distribution and liquidation rights (voting rights can differ)
  • Not an ineligible corporation — banks, insurance companies, and certain international sales corporations cannot elect S-Corp status

4. Filing Deadline

  • For existing entities (calendar year): File by March 15 of the year you want the election to take effect
  • For new entities: File within 2 months and 15 days of the date the entity begins operations
  • Late election relief: Available under Rev. Proc. 2013-30 for up to 3 years and 75 days after the intended effective date
  • The IRS does not accept Form 2553 electronically — must be filed by mail or fax

5. Where to File

  • Fax: 855-214-7520
  • Mail: Department of the Treasury, Internal Revenue Service Center, Ogden, UT 84201-0023 (or Kansas City, MO 64999-0023 depending on state)

6. Factors the IRS Considers

  • Training, education, and experience of the owner
  • Duties and responsibilities performed
  • Time and effort devoted to the business
  • Comparable salaries for similar positions in the industry and geographic area
  • Company revenue and profitability
  • Dividend history and distribution amounts

7. Common Misconceptions

  • The "60/40 rule" is a myth — there is no IRS-endorsed formula for splitting salary vs. distributions. The 60% salary / 40% distribution split has no legal standing and has been explicitly rejected by tax courts.
  • Each situation requires individual analysis based on market rates, actual duties, and specific circumstances.
  • Setting salary too low (e.g., $20K for a full-time business generating $200K) will trigger IRS scrutiny and potential reclassification of distributions as wages plus penalties.

8. Penalties for Non-Compliance

  • IRS can reclassify distributions as wages, subjecting them to payroll taxes retroactively
  • 20% accuracy-related penalty on the underpaid tax
  • Interest on unpaid payroll taxes
  • Both the employer and employee portions of FICA taxes become due

9. Income Threshold

  • Below this threshold, the payroll tax savings are offset by the additional compliance costs
  • Additional costs include: payroll processing ($500-$2,000/year), S-Corp tax return preparation ($500-$1,500/year), and quarterly payroll tax filings

10. Good Fit

  • Profitable businesses with consistent income over $80,000/year
  • Owner actively works in the business (can justify reasonable salary)
  • Business has predictable, stable income
  • Owner is willing to handle payroll compliance

11. Poor Fit

  • Businesses with net income under $50,000/year (compliance costs exceed savings)
  • Businesses with highly variable income (hard to set reasonable salary)
  • Businesses planning to raise VC investment (investors prefer C-Corp for QSBS)
  • Real estate businesses relying on depreciation (S-Corp basis rules are less favorable)
  • Businesses with multiple classes of ownership interests

Sources

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