S Corporations – Filing The Election
The S corporation election is an important form of business entity that can be used to pass through income limits for the self-employed. The IRS has an S election form, available at https://www.irs.gov/pub/irs-pdf/f1040s-selection.pdf, which is used to form an S corporation and elect it as a disregarded entity for federal income tax purposes. An S Corporation needs to file annually with the IRS if it elects to be treated as a disregarded entity under Internal Revenue Code Section 535(a).
To file this type of tax return electronically, individuals must enroll in e-File Signature Authorization on irs.gov, have a FSA-compliant personal identification number (PIN), and they must use a software provider or tax professional authorized to e-file Form 1120S. Businesses that make the S corporation election but do not file the required information returns on time are subject to failure-to-file penalties. An S corporation that fails to file a timely return for its first taxable year of existence may be assessed an automatic 60-percent penalty on late payments attributable to the missing return.
Another requirement is Form 8932, which must be filed with the appropriate service center when an eligible entity wants to be treated as an S corporation under IRC Section 1362(a)(1) and 544(a). In order to make the election, an S corporation must elect to be treated as a disregarded entity. The election can only be made annually with IRS Form 8832, which can be downloaded from IRS.gov.
Filing Requirements
To file the S corporation election and a Form 8932, the S corporation must meet several requirements. These requirements are part of IRC Section 1362(a)(1) and (a)(2), 544(a)(1)(A) and (B), and 544(b):
S corporations must have at least one shareholder other than their owners/members to create an aggregate investment of more than $50,000 in assets.
The S corporation must have only one class of stock with unlimited voting rights and limited rights to dividends.
S corporations must not have more than 100 shareholders.
S corporations cannot be foreign organizations, except for a qualified subchapter S subsidiary.
S corporations can only be formed by domestic entities or eligible entities (e.g. foreign entities allowed for disregarded treatment). Foreign entities are not eligible for S corporation status unless the entity is a qualified subchapter S subsidiary owned by the same individuals as the parent or another qualify subchapter S subsidiary.
S corporations are taxed on their income at the entity level. As a result, it is important to consider all of the potential tax advantages and disadvantages when deciding whether to form an S corporation as opposed to another form of business entity.
Income from an S corporation may be eligible for reduced self-employment tax rates if the S shareholder receives qualifying wages during the year. An election for reduced SE tax rates must be made by filing Form 8941 and attaching required information documentation with your personal income tax return.
S corporations may elect to be taxed under Subchapter C using Form 2553 instead of Form 1120S. The election may only be made once per taxable year. Form 2553 is used to make the election and is also required to notify the IRS of changes that may affect eligibility for Subchapter C tax status.
S corporations can elect to use Subchapter S instead of Subchapter C of the Internal Revenue Code. An entity must make this choice on Form 2553 when filing its first federal income tax return after becoming an S corporation or if it makes a change in its method of accounting. The election may be revoked with IRS form 8809 when a change in method of accounting occurs, such as when an S corporation becomes a C corporation or returns to being a regular corporation or partnership.
The Subchapter S election is used by an S corporation with 100 shareholders or more to operate as an electing small business corporation under section 1371(b)(1)(B) of the Internal Revenue Code. Under Subchapter S, the S corporation and its shareholders are taxed at individual tax rates instead of at corporate tax rates. This results in significant tax savings because the S corporation and its shareholders pay tax on their income on Schedule E (Form 1040).
The total earnings and profits of an S corporation are subject to self-employment taxes (Social Security, Medicare, and Federal Unemployment Tax Act) calculated using a percentage method. The percentage is determined using simplified deduction tables that are found in the Internal Revenue Code. The IRS provides four deduction tables that cover zero to 100 shareholders and an additional table for more than 100 shareholders. The tables are found in IRS Publication 533, Tax Information for S-corporation Shareholders.
Like C corporations, S corporations must file a corporate tax return (Form 1120S), but income and expenses flow through to the shareholders. Unlike the 15 percent maximum corporate tax rate of a C corporation, an S corporation is generally taxed at individual rates. There are three different rates depending on filing status: 10 percent, 25 percent or 28%. All regular income items are included in computing taxable income for an S corporation tax return. S corporations that have 100 or fewer shareholders can elect to be taxed under Subchapter S.
The salaries and other compensation paid to executives, officers, general partners, and shareholders by a corporation are considered self-employment income and are subject to self-employment tax. The only exception is if the corporation pays a reasonable wage of $600 or more per year to another person for services rendered in the capacity as an officer or employee of the corporation. If this exception applies, then the income paid for services is treated as employee compensation and not as self-employment income.
Self-employment tax is calculated on the net earnings of an S corporation as follows:
The self-employment tax rate for an S corporation is 15% for the first $106,800 of net earnings, 10.4 percent for the next $106,800 to $107,200 or up to 25 percent of net earnings over $107,200. The rates double if the taxpayer has two or more full-time employees (one full-time employee would be considered a full-time employee if he or she works at least 1,000 hours per year). For part-time self-employed individuals, these rates are 20.4 percent and 26 percent respectively.
Conclusion
The net earnings of an S corporation are subject to self-employment tax. The self-employment tax rate is the same as the corresponding C corporation, regardless of whether or not the S corporation has more than one class of stock or any separate classes have different income and deductions in addition to wages. The employee compensation amount is only excluded if it is reasonable compared to wage payments made by other corporations that do not employ individuals. It may be prudent for S corporations with 100 or more shareholders to opt out of Subchapter C based on being taxed at individual rates while having 100 or more shareholders and similar dollar amounts paid in wages so that this deduction would be excluded.