What the election does
An S corporation elects to pass corporate income, losses, deductions and credits through to its shareholders for federal tax purposes. The shareholders report that income on their personal returns and pay tax at individual rates. The business itself files Form 1120-S each year.
The election is made on Form 2553, Election by a Small Business Corporation. A limited liability company can make it too: an eligible entity that files Form 2553 is treated as a corporation from the effective date, so it does not need a separate Form 8832. If you are still choosing a structure, the guide to sole proprietorship vs LLC covers that step first.
Who can elect
- Domestic. A US corporation, or a domestic entity eligible to elect to be treated as one.
- No more than 100 shareholders. A married couple, and certain family members, can count as one.
- Allowed shareholders only. Individuals, estates, certain trusts and certain exempt organizations. No partnerships, no corporations and no nonresident alien shareholders.
- One class of stock. Differences in voting rights alone are allowed.
- Not an ineligible corporation, such as certain banks, insurance companies and a DISC or former DISC.
An authorized officer signs the form, and every shareholder has to consent by signing. An unsigned form is not considered timely filed.
The deadline: 2 months and 15 days
Form 2553 has to be filed no more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year before. The IRS instructions give the calendar-year example: the 2 months end on the last day of February, and 15 days later is March 15.
| S status from | 2 months end | File by |
|---|---|---|
| January 1, 2027 | February 28, 2027 | March 15, 2027 |
| January 1, 2028 | February 29, 2028 | March 15, 2028 |
Filing at any time during the year before also works, so a business that decides in the fall can file then for the following January. A missed deadline can sometimes be fixed under Rev. Proc. 2013-30, generally within 3 years and 75 days of the intended effective date, with reasonable cause and the words "FILED PURSUANT TO REV. PROC. 2013-30" at the top of the form.
The reasonable salary rule
The tax saving only exists because profit paid out as a distribution does not carry payroll tax. The IRS closes the obvious gap: an S corporation must pay reasonable compensation to a shareholder-employee for services before non-wage distributions. If the salary is too low, the IRS can reclassify distributions as wages subject to employment taxes.
The IRS lists the factors it looks at, among them:
- training and experience,
- duties and responsibilities,
- time and effort devoted to the business,
- what comparable businesses pay for similar services,
- payments to non-shareholder employees and dividend history.
It also points to where the money comes from. Receipts generated by the shareholder's own personal services point to wages; receipts from other employees or from capital and equipment point to distributions. For a one-person consulting business, most receipts come from the owner's own work, which under that test points to wages.
The self-employment tax arithmetic
As a sole proprietor, or an LLC taxed like one, the owner pays self-employment tax: 12.4 percent Social Security plus 2.9 percent Medicare, 15.3 percent in total, on 92.35 percent of net earnings. In an S corporation the owner is an employee instead. The salary pays 7.65 percent from the employee and 7.65 percent from the company, the same 15.3 percent, and the remaining profit pays neither.
Take $100,000 of profit before paying the owner. Without the election, self-employment tax is $100,000 × 92.35% × 15.3% = $14,129.55. With the election, the table shows three possible salaries. The example treats the employer's share as a business cost, so the profit left to pass through is the profit minus the salary minus that share.
| Salary | Payroll tax, both halves | Pass-through profit | Lower than SE tax by |
|---|---|---|---|
| $40,000 | $6,120.00 | $56,940 | $8,009.55 |
| $60,000 | $9,180.00 | $35,410 | $4,949.55 |
| $80,000 | $12,240.00 | $13,880 | $1,889.55 |
At a $60,000 salary, payroll tax is $4,590.00 from the paycheck plus $4,590.00 from the company, $9,180.00 in total, against $14,129.55 of self-employment tax. The gap of $4,949.55 is the gross saving. The Social Security part of both taxes stops at a yearly wage base; all the figures here are below it.
Income tax does not disappear. The salary and the pass-through profit are both taxed on the owner's personal return. The election also changes the QBI deduction, because qualified business income does not include reasonable compensation received from an S corporation. A higher salary lowers payroll-tax savings and the QBI base at the same time; see the guide to the QBI deduction.
What the saving has to cover
The election brings work that a sole proprietor does not have: running payroll with withholding and payroll returns, a separate Form 1120-S each year, and keeping salary and distributions apart. Those costs come out of the gross saving. A business with a small profit, or one where a reasonable salary is close to the whole profit, may save little or nothing. The self-employment tax calculator gives the first side of the comparison, the paycheck calculator shows what the salary nets after withholding, and the employee cost calculator adds the employer's side.
Before you file Form 2553
- Check the shareholder limits: 100 or fewer, all allowed types, no nonresident aliens.
- Confirm one class of stock.
- Set a salary you can support with the IRS factors.
- Run the arithmetic with your own profit and salary, then subtract the extra costs.
- File by March 15 for a calendar year, with the officer's signature and every shareholder's consent.
Frequently asked questions
What is an S corp election?
It is a choice a corporation, or an LLC that is eligible to be taxed as one, makes on Form 2553 to be taxed under subchapter S. The business then passes its income, losses, deductions and credits through to the shareholders, who report them on their own returns. The corporation files Form 1120-S.
When is the Form 2553 deadline?
No more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year before. For a calendar-year business that wants S status from January 1, that means March 15. Late elections can sometimes be fixed under Rev. Proc. 2013-30, generally within 3 years and 75 days.
Who can be an S corporation?
A domestic corporation, or an eligible domestic entity, with no more than 100 shareholders and only one class of stock. Shareholders must be individuals, estates, certain trusts or certain exempt organizations. Partnerships, corporations and nonresident aliens cannot be shareholders.
Do I have to pay myself a salary in an S corp?
Yes, if you work in the business. The IRS says an S corporation must pay reasonable compensation to a shareholder-employee for services before making non-wage distributions. The IRS can reclassify distributions as wages subject to employment taxes if the salary is too low.
How much tax does an S corp save?
It depends on profit and on the salary that is reasonable for your work. Only the salary pays Social Security and Medicare tax; the rest of the profit does not. In this guide's example of $100,000 profit and a $60,000 salary, payroll taxes are about $4,950 lower than self-employment tax, before the extra costs of running payroll and filing a corporate return.
Sources
- IRS Instructions for Form 2553 (eligibility; 100 shareholders; one class of stock; 2 months and 15 days; March 15 example; officer and shareholder signatures; late election relief under Rev. Proc. 2013-30 within 3 years and 75 days; eligible entities need not file Form 8832)
- IRS: S corporations (pass-through of income, losses, deductions and credits; Form 1120-S; shareholders report on personal returns; allowable shareholders; Form 2553 signed by all shareholders)
- IRS: S corporation compensation and medical insurance issues (reasonable compensation before distributions; recharacterization as wages; factors the IRS lists)
- IRS Topic no. 554, Self-employment tax (12.4% plus 2.9%; 92.35% of net earnings; deduction for half of the tax)
- IRS: Qualified business income deduction (QBI does not include reasonable compensation received from an S corporation)
- IRS Topic no. 751, Social Security and Medicare withholding rates (6.2% and 1.45% each for employer and employee; 0.9% Additional Medicare Tax above $200,000 of wages)
General information based on the sources above, not tax, legal or financial advice.