By Nellie Akalp
The deadline for existing limited liability companies and C Corporations to elect S Corporation tax treatment for the tax year 2022 was March 15. So, what happens if a business missed the S Corp deadline? Can it still change its LLC or C Corp tax treatment from its default status to that of an S Corporation?
These are important questions for business owners who are striving to optimize their tax outcomes and maximize their profitability.
S Corporation overview and eligibility requirements
What is an S Corp?
Before we dig into the deadline issue, let’s first discuss what it means to be an S Corporation. An S Corporation is not an entirely different type of business entity. Rather, it is a special pass-through tax election that an LLC or C Corporation requests through the IRS.
Pass-through tax status means that an S Corporation’s business income, losses, deductions, and credits flow through to its owners. While an LLC is by default a pass-through entity, pass-through taxation as an S Corp is handled a little differently—more on that later. An LLC or corporation must file Form 2553 (election by a small business corporation) to request S Corporation tax treatment.
S Corp eligibility requirements
A business must meet the IRS’s criteria to qualify to be taxed as S Corporation:
- Must be a domestic corporation (or LLC).
- May not have more than 100 shareholders (or LLC members).
- May not have owners that are non-resident aliens, partnerships, or corporations. All shareholders in an S Corporation must be individuals (not LLCs or partnerships) and legal residents of the United States.
- An S Corp may have only one class of stock. Owners must share equally in terms of profits and losses based on their percentage of ownership.
- Organizations that are not eligible to be treated as S Corps include certain financial institutions, insurance companies, and domestic international sales organizations.
C Corporation electing S Corporation status: Tax treatment overview
Normally, a C Corporation files a corporate income tax return and pays income tax on its profits at the corporate tax rate. Some of its earnings are subject to “double taxation”; i.e., some of a corporation’s profits get taxed when the C Corp earns that income and when the company distributes those profits as dividends (which are not tax-deductible) to its shareholders.
After the corporation pays income tax on those monies at the corporate tax rates, shareholders also report and pay tax on the income on their personal tax returns at their individual tax rates.
Alternatively, a corporation that has elected to be treated as an S Corporation is considered a pass-through entity. Therefore, its profits and losses flow through to its shareholders’ personal tax returns (according to their shares of ownership). The shareholders pay tax on that income at the applicable individual tax rates, but the business does not pay income tax on the profits. Therefore, S Corp taxation eliminates the “double taxation” that applies to corporations under their default tax treatment.
Shareholders who are employees of the C Corporation pay Medicare and Social Security taxes (FICA taxes) only on the wages and salaries the company pays them. Dividend income they receive is not subject to Social Security and Medicare taxes.
While a C Corp electing S Corp status follows a different income tax protocol, its corporate compliance obligations for the underlying business entity type (C Corporation) remain the same. For example, the corporation must adopt bylaws, designate a registered agent, appoint a board of directors, hold shareholder meetings, etc.
S Corporation advantages for C Corporations
Avoiding double taxation stands as the primary reason entrepreneurs with C Corporations elect S Corporation status. Generally, the tax filing process as a pass-through tax entity is less complicated, too.
S Corporation disadvantages for a C Corporation
S Corp election may not be ideal for every C Corporation because it offers less flexibility in certain respects:
- S Corp election places restrictions on who is eligible to own the corporation.
- Business income or loss is allocated in direct proportion to each shareholder’s ownership percentage of the corporation. For example, suppose shareholder 1 owns 60% of the corporation and shareholder 2 owns 40%. Shareholder 1 will be taxed on 60% of the profits and shareholder 2 will be taxed on 40% of the profits, regardless of other agreements made about dividing profits.
- Because an S Corp may only have 100 or fewer shareholders, the corporation’s ability to raise capital and fund growth may be limited.
These are some of the potential downsides for business owners to consider.
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LLC electing S Corporation status: Tax treatment overview
An LLC is a pass-through tax entity, with its profits flowing through to its members’ personal tax returns. LLC members must pay income tax and self-employment taxes (Social Security and Medicare) on all the company’s profits.
With S Corporation election, LLC members only pay Social Security and Medicare taxes on income paid to them as wages and salaries. The profits the company gives them as distributions are not subject to Social Security and Medicare taxes.
An LLC faces the same LLC business compliance formalities regardless of whether it opts for default or S Corp tax treatment. For example, it must maintain a registered agent in the state, apply for required licenses and permits, and obtain an EIN. However, becoming an S Corporation for tax purposes does not burden an LLC with C Corp compliance requirements like adopting bylaws or appointing a board of directors.
S Corporation advantages for LLCs
LLC members may be drawn to S Corp election because it may help them lower their personal tax burden. Income paid to business owners through payroll is subject to Social Security and Medicare taxes (FICA), while profit distributions are subject to income tax but not FICA taxes.
S Corporation disadvantages for LLCs
On the flip side, some potential drawbacks exist:
- The IRS restricts who may own an LLC.
- LLC members who work in the business must compensate themselves with a sensible salary or wage. If they try to get away with paying as little FICA tax as possible by paying themselves an unreasonably low salary and taking a disproportionate amount of money in distributions, it could raise red flags with the IRS.
- Managing payroll for LLC members adds extra work and administrative considerations for LLCs that otherwise would not have employees.
- Filing taxes as an S Corp is more complex than filing as an LLC.
What about the 2022 S Corp election deadline?
To be considered an S Corporation for tax purposes in all of 2022, existing LLCs and C Corporations that follow a January 1–December 31 tax year had to submit an IRS Form 2553 by March 15, 2022 (two months and 15 days after the start of the 2022 tax year).
If they missed that deadline, they can still file Form 2553, but the election will only be effective for the remainder of the year. That means, they will have two sets of income tax files to deal with.
So, say an existing LLC missed the deadline and filed its Form 2553 on May 1, 2022.
- For January 1–April 30, 2022, it must file taxes as an LLC.
- For May 1–December 31, 2022, it must file taxes as an S Corp.
Businesses that follow a fiscal year other than the calendar year have until two months and 15 days (75 days) after the start of their fiscal year to file for S Corp election.
New LLCs and C Corporations registered in 2022 have two months and 15 days (75 days) from their formation date to file for S Corp tax treatment for their first tax year.
Businesses have flexibility if they want their S Corp tax treatment to take effect starting with their 2023 tax year. They can file their Form 2553 anytime during tax year 2022 to make it effective for 2023.
Leeway for businesses that miss their deadline
If an LLC or corporation demonstrates it has reasonable cause for not filing Form 2553 on time, the IRS may approve the S Corp election retroactively to the beginning of the company’s tax year. Business owners must include an explanation on Form 2553 of why they’re submitting their filing late.
Should your business elect S Corporation status?
Before moving forward with filing for S Corp election, it’s helpful to talk with a tax advisor or accountant and attorney to determine if the change makes sense for your situation. There are pros and cons, so it’s important to understand all the ways S Corporation status will impact your company.
About the Author
Nellie Akalp is Founder and CEO of CorpNet.com, a trusted resource and service provider for business incorporation, LLC filings, and corporate compliance services in all 50 states. See Nellie’s articles and full bio at AllBusiness.com.