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LLC Taxed as an S-Corp (Form 2553)
Table of contents:
(click link to skip to section)
• What is an S-Corp?
• “Forming” an S-Corp
• LLC tax classification with IRS
• S-Corp benefits
• Disadvantages of S-Corps
• Reasonable salary
• When to file Form 2553
• Late election of S-Corp status
• Requirements for S-Corp
• Who can own an S-Corp
• Can foreigners own S-Corps
• Convert llc to S-Corp
• How to fill out Form 2553
• Where to mail/fax Form 2553
• S-Corp approval letter
• Form 1120S and S-Corp taxes
• State S-Corp tax filings
• How to revoke S-Corp status
• IRS contact information
S-Corp is short for S-Corporation, also known as an “S Corp”, “S Corporation”, or “Subchapter S Corporation”.
An S-Corporation is different than an LLC or Corporation (C-Corporation) in that it is a “tax entity”, not a legal entity formed at the state-level.
The term “tax entity” means it’s a tax classification status made with the IRS.
The S-Corporation election is made with the IRS and then “sits on top of” your legal entity; either your LLC or your C-Corporation.
An S-Corporation is a “pass through” tax entity, so it is not subject to double taxation like a C-Corporation. Any income, losses, credits, and deductions flow through to the owners of an S-Corporation (called shareholders) and will be reported and paid for on their personal tax return.
Just like an LLC and a C-Corporation, an S-Corporation offers personal liability protection to its owners. Their personal assets (like homes, vehicles, and bank accounts) are protected in the event of a lawsuit and cannot be used to pay off the debts or liabilities incurred by the S-Corporation.
A lot of people use the term “forming an S-Corporation” and this causes a lot of confusion.
Again, unlike an LLC or a Corporation, which is a business entity created at the state-level, an S-Corporation is a tax entity selection made with the IRS.
Therefore, you can’t form an S-Corporation. Instead, you elect to have your already-formed entity taxed as an S-Corporation with the IRS.
Meaning, you first need to form an LLC or a Corporation (making the appropriate filing with your state’s Secretary of State office), then elect to have that entity taxed as an S-Corporation with the IRS.
I highlighted “taxed as” because that is the proper verb, not “form” an S-Corp. There is no filing in any of the 50 states to “form an S-Corp“. A better way to refer to this is “setting up an S-Corp“.
Again, “forming an S-Corp” simply means taking an existing entity and changing its tax status with the IRS.
Having said that, traditionally speaking, when people say “form an S-Corp”, they actually mean form a Corporation (also known as C-Corporation) with the state, then elect for the C-Corporation to be taxed as an S-Corporation by the IRS. However, an LLC can also elect to be taxed as an S-Corporation with the IRS, and is a very common tax classification made by LLCs whose net income begins approaching $75,000 to $100,000 per year.
Note: This lesson will focus on LLCs taxed as S-Corporations, not Corporations taxed as S-Corporations.
LLCs have a default tax status with the IRS, depending on how many members there are:
• If you have a Single-Member LLC (1 owner), then the IRS will tax it as a Disregarded Entity/Sole Proprietorship.
• If you have a Multi-Member LLC (2 or more owners), then the IRS will tax it as a Partnership instead.
Alternatively, you can tell the IRS to tax you as a Corporation by filing an additional form after getting an EIN for your LLC. There are two different ways you can have your LLC taxed as a Corporation:
• You can have your LLC taxed as an S-Corporation by filing Form 2553 (which we’ll discuss in this lesson).
• You can have your LLC taxed as a C-Corporation by filing Form 8832.
S-Corporations are becoming very popular for small business owners (with adequate net income), but S-Corporations are also the least understood (and people usually jump into them too fast).
Let’s now discuss the S-Corporation advantages and disadvantages.
The primary benefit of an LLC taxed as an S-Corporation is saving money on self-employment taxes.
Self-employment tax refers to Social Security and Medicare taxes, which total 15.3% of your net income (income minus expenses). The breakdown is 12.4% for Social Security tax and 2.9% for Medicare tax.
The way an S-Corporation saves money on self-employment taxes is by “splitting your income” into two groups:
- salary (also called wage or payroll) and
- distribution (also called dividend or profit)
Once your LLC is taxed as an S-Corporation you become an “employee-owner” (also referred to as a “shareholder-owner”). You both own your company and work for your company.
With this “income splitting”, you only have to pay the 15.3% self-employment tax on your salary. Your extra money left over (called distributions) is not subject to self-employment tax.
This is unlike an LLC taxed as a Sole Proprietorship or Partnership. In these tax classifications, you pay self-employment tax on all of your net income and there is no option to split your income and save money on self-employment tax.
However, the IRS is not an idiot and they know that there is a slight loophole in the S-Corporation tax election. Therefore, they require you to take what’s called a “reasonable salary”, which we’ll discuss more in a bit.
Let’s first look at an example:
Let’s say your LLC is a web design business and has a gross income of $120,000 and your expenses are $20,000. Your net income is therefore $100,000.
You and your accountant decide on a reasonable salary of $60,000 per year, which is average for your industry.
You’ll end up paying 15.3% self-employment tax on the $60,000 wage, but the remaining $40,000 in distributions (profit) will not be subject to the 15.3% self-employment tax, therefore you’ll save $6,120 in taxes.
Now it’s not pure tax savings though. Your administrative costs will offset your savings a little, however, for most businesses with a net income of $75,000 to $100,000 per year (or more), the tax savings are usually still greater than the expenses.
Here are your S-Corp administrative responsibilities:
- you have to run payroll,
- you have to file quarterly payroll returns (federal and state),
- you have to keep accurate books and a balance sheet, and
- you should hire an accountant to file your corporate tax return (Form 1120S, K-1s for shareholders/owners, and any additional Schedules)
Also, depending on the number of employees you have and in what state you’re located, you’ll also need to take care of federal unemployment insurance, state unemployment insurance, and workers’ compensation insurance.
The costs of the above will vary depending on your business and situation, but as a per-year-ballpark, payroll can cost $400 to $600, accounting and bookkeeping also at $400 to $600, and tax prep services paid to your accountant can range from $700 to $1,000.
So overall, your administrative costs may be $1,500 to $2,500 (maybe up to $3,000 in some cases). So you spend $3,000 to save $6,120, for a net tax savings of $3,120.
And granted, the higher your company’s profits, the more you can save on self-employment tax.
But that’s not all there is consider. There are also disadvantages to S-Corp taxation.
Although you can save money with an S-Corporation, it’s important to understand the other side of the coin.
Higher audit risk:
S-Corporations are more closely watched by the IRS so make sure you are actually taking a reasonable salary and filing your federal and state taxes correctly.
Social Security benefits:
Your Social Security benefits are based off the salary you take over your working career. In an S-Corporation, that means your Social Security benefits are based off the salary you pay yourself. The distribution of profits you pay to yourself do not count. So although you’ll be saving money on self-employment taxes by taking a lower salary now, you could be reducing your Social Security benefits in the future.
Lower mortgage pre-approval:
When purchasing a home with a traditional mortgage, the bank will look at your income to determine how much you can afford. They’ll only be looking at the salary paid by your S-Corporation and not the dividends. So making your salary too low could hurt your ability to purchase a more expensive home.
Self-employed retirement account contributions:
If you have a self-employed retirement account (like an SEP, simple IRA, solo 401(k), or Keoghs), the contributions you can make are based off the salary your S-Corporation pays you. Not only does making these retirement account contributions reduce your tax burden, they also help you maximize your retirement funds. For additional reading, see this article by The Tax Advisor.
As you can see, the S-Corporation tax savings are not always 100% beneficial. We recommend speaking with an accountant regarding saving money on taxes while balancing that with long-term tax and retirement strategies.
At this point, you may be thinking, “How do I determine a reasonable salary?”
Here are some factors to consider:
- experience, training, and certifications
- duties and responsibilities
- history of prior dividend payouts
- the time and effort you provide to the business
- how much you pay regular employees (if applicable)
- what similar business pay employees for similar services
- if there is use of a formula to determine compensation
As a general rule of thumb, it’s good to document how your time is spent in the business, and what the appropriate salary is for each of those activities.
For example, let’s say you spend 50% of your time on web design, 25% on marketing, and 25% on customer service. And let’s also assume you work a 40-hour workweek and work 50 weeks per year (taking a 2-week vacation).
Here’s a recommendation:
Find the salary of each role on the above 2 sites and average them out. We recommend printing/saving your findings for good documentation.
In our example:
– a web designer’s average salary came to $65,000 per year,
– a marketing coordinator’s salary came to $46,500 per year, and
– a customer service representative’s salary came to $32,600 per year.
We then took 50% of the web design salary ($32,500), 25% of the marketing coordinator salary ($11,625), and 25% of the customer service representative salary ($8,150) to arrive at a total salary of $52,275.
Of course this is just an example. There are many factors to consider when determining your S-Corporation salary. We recommend speaking with your accountant, and however you determine your salary, make sure you document it in case of an audit in the future. It’s also advisable to draft and sign a compensation agreement between you and your S-Corporation.
• Some tax advisors recommend keeping your distributions no more than 3x your salary. For example, if your net income is $150,000, your salary is $50,000 and your distributions are $100,000.
• More conservative tax advisors say to keep your distributions at 50% of your net income. For example, if your net income is $150,000, your salary is $75,000 and your distributions are $75,000.
The IRS can reclassify distributions:
On another note regarding S-Corporation reasonable compensation, it’s important to remember that if at some point, the IRS determines that your salary is not reasonable, they can reclassify the distributions you already took, tax them, and add on penalties, interest, and fines.
These federal cases show the IRS’ ability to reclassify distributions:
https://www.ustaxcourt.gov/InOpHistoric/vetsurg.TC.WPD.pdf (Veterinary vs. IRS)
http://media.ca8.uscourts.gov/opndir/12/02/111589P.pdf (Watson vs. USA)
https://www.ustaxcourt.gov/InOpHistoric/JOLY.TCM.WPD.pdf (Joly vs. IRS)
https://www.ustaxcourt.gov/InOpHistoric/Gre5y.TC.WPD.pdf (Great Public Accountant vs. IRS)
The time for filing Form 2553 will depend on whether your LLC is newly-formed or already existing.
For already-existing LLCs:
If you want to make your LLC’s S-Corp status effective for a given tax year, you have to file Form 2553 within 2 months and 15 days from the beginning of that year.
If you file beyond that given period, the effectivity will start the next tax year.
Example: Your LLC (assuming the beginning of its next tax year starts January 1st, 2018) must file Form 2553 on or before March 15th, 2018. If you file within that period, then the S-Corp status takes effect in the 2018 tax year. If you file after March 15th, then the status takes effect in the 2019 tax year instead.
For newly-formed LLCs:
You have to file within 2 months and 15 days from the date of your LLC’s date of formation in order for the changes to take effect in its first tax year.
Example: If your LLC was formed on April 10th, 2018, then you have until June 25th, 2018 to file Form 2553 for the S-Corp status to take effect for the 2018 tax year. If you file after June 25th, then the status takes effect in the 2019 tax year instead.
How do you know if your LLC is already-existing or newly-formed?
• If your LLC has already had a prior tax year, then your LLC is already-existing.
• If your LLC has not had a prior tax year, then your LLC is newly-formed.
If you filed your Form 2553 beyond the two-month-and-15-day window but want your LLC’s S-Corp status to take effect for that current tax year, you must prove that the late filing was due to a “reasonable cause.”
So as long as you have a “reasonable cause” and your LLC meets the IRS requirements, the IRS will usually grant your LLC S-Corp status to take effect in its current tax year.
We recommend speaking with your accountant about the details, but you can see the common reasonable cause example of “blaming your accountant” below.
Special note to add in the top margin:
• If you are making the S-Corp late election when filing Form 2553 (but don’t need to file Form 1120S), write “FILED PURSUANT TO REV. PROC. 2013-30” at the top of page 1 of Form 2553.
• If you are making the S-Corp late election when filing Form 2553 along with Form 1120S, write “INCLUDES LATE ELECTION(S) FILED PURSUANT TO REV. PROC. 2013-30” at the top of page 1 of Form 1120S.
Don’t go S-Corp too fast
Although having your LLC taxed as an S-Corp sounds amazing at first glance, it’s important to proceed with caution and not move too fast.
Many small business owners may be able to save money on taxes by keeping their LLC in its default tax status (taxed as a Sole Proprietorship or taxed as a Partnership) for the first few years until net income increases.
You want to make sure your LLC is consistently hitting net income levels that are above what the LLC Member(s) reasonable salary would be.
Note: In this context below (since your LLC will be taxed as an S-Corp), a shareholder of an S-Corporation is the same thing as an owner/member of an LLC.
In order for your LLC to be eligible to be taxed as an S-Corp, it must meet the following requirements:
1. US entity. Your LLC must be formed in the United States and cannot be a company that was formed or organized outside of the US.
2. 100 shareholders. You’ll often see this rule written as “your S-Corporation can’t have more than 100 shareholders”. In the context of an LLC taxed as an S-Corporation, this means your LLC cannot have more than 100 members.
3. Class of stock. The company can only have 1 class of stock. Sometimes companies have different classes of stock which have different rights and privileges. All shareholders (owners) of an S-Corporation must all receive the same privileges of ownership.
4. Eligible shareholders. Under the IRS rules, an S-Corporation can only have eligible owners/shareholders.
The following are allowed to be owners (shareholders) of an S-Corporation:
– US citizen
– US trust
– US estate
– US resident alien (must have Green Card/Form I-551 or pass “substantial presence test”)
– US tax-exempt organizations (must qualify under 26 US Code § 401(a), 501(a), or 501(c)(3))
The following are not allowed to be owners (shareholders) of an S-Corporation:
– non-resident alien
– foreign company
– financial institution
– insurance company
– domestic international sales corporation
Yes, a foreigner can own an S-Corporation, but it depends. For more clarification on what type of “foreigners” can own an S-Corporation, see here:
A lot of our readers ask us how to convert an LLC to an S-Corporation. We just want to add this section as clarity.
Just like “forming an S-Corp” is not the correct expression, “converting from LLC to S-Corp” is also not the correct expression and it can lead to a lot of confusion.
The legal and state entity (the LLC) remains the same. You are just changing the way in which the IRS taxes your LLC. The LLC does not go away. Remember, by default, LLCs with 1 owner are taxed as a Sole Proprietorship and LLCs with 2 or more owners are taxed as a Partnership.
By filing Form 2553 with the IRS (instructions below) you are simply changing the default tax classification of the LLC (from either Sole Proprietorship or Partnership) to S-Corporation, under Subchapter S of the IRS Revenue Code.
Additionally, the instructions below are for an LLC electing to be taxed as an S-Corp (not a Corporation electing to be taxed as an S-Corp).
Download IRS Form 2553 and save to your computer.
If you’d also like to download a completed sample form, please download this file as well: LLC taxed as S-Corp Form 2553 example
Part 1 – Election Information
Enter your complete LLC name in this section.
Employer Identification Number (A):
Enter your LLC’s EIN Number in this section. You’ll need an EIN in order to make the S-Corporation tax election.
Street Address and City, Town, Zip:
Enter the street or mailing address for your LLC. This can be the same address you used when you applied for your EIN, but it doesn’t have to be. If this is an updated address you’re using with the IRS, check off the “address box” in D.
Date incorporated (B):
Enter the date your LLC was formed. You can find this date on your stamped and approved Articles of Organization (or Certificate of Organization or Certificate of Formation) or by searching your LLC name on your state’s LLC name search database.
State of incorporation (C):
Enter the state where you formed your LLC.
If you’re using a new address with the IRS, check off the “address” box. If you’ve changed your LLC name with the state since forming your LLC, check off the “name” box.
E (Election is to be effective):
Enter the tax year that you’d like your LLC to be taxed as an S-Corp. For example, if you’d like your LLC to be taxed as an S-Corp in the 2018 tax year, enter “01/01/2018”.
F (Selected tax year):
Choose your tax year. Most filers check off the first box for “Calendar year”.
G (Treating members of a family as one shareholder):
This section applies if your LLC has more than 100 members (also known as your S-Corporation having more than 100 shareholders). If your S-Corporation has more than 100 shareholders, please review the instructions. For most filers, their S-Corporations do not have more than 100 shareholders, so this box will be left unchecked.
H (Name and title of officer):
Enter your contact information and title in case the IRS has any questions. For example, you can enter “John Doe, Member” or “John Doe, Owner”.
I (Phone number):
Enter your cell, office, or home telephone number.
Multi-line explanation section:
This multi-line section is only needed if you are making a late S-Corp election (after the due date). If that’s the case, you need to include a reason, and often, the IRS is fairly flexible on accepting Form 2553 after the deadline.
A common strategy to use is the “blame the accountant” method. Here’s example text you could use: “LLC intended to make the S-election. Accountant did not provide the recommendation on time.”
Signature, Title and Date:
Enter “Member” or “Owner” for the title, and the date which you are completing the form. After you print the form, make sure to sign it.
Part 1 – Election Information (continued) [page 2]
On page 2 you are going to list all of your LLC owners.
In column J, you’re going to list each person’s full name and address.
In column K, you’re going to have each person sign and enter today’s date.
In column L, you’re going to list the percentage of ownership and the date which the ownership was acquired. If you have 1 member in your LLC, the percentage would be 100%. If you have 2 members in your LLC, each person would enter 50%. For the date acquired, you can use the date your LLC was formed (which you also entered in box B).
In column M, list each person’s Social Security Number.
In column N, enter each person’s calendar year. This will be “12/31”.
For most filers, there is nothing else you need to do with the form. You can skip ahead to the mailing/fax instructions.
Part 2 – Selection of Fiscal Year (O, P, Q, and R):
This section does not apply to most filers, so they leave everything blank, however make sure to review your filing and speak to your accountant if anything in this section needs to be completed.
Part 3 – Qualified Subchapter S Trust (QSST):
This section does not apply to most filers, so they leave everything blank, however make sure to review your filing and speak to your accountant if anything in this section needs to be completed.
Once you complete Form 2553 and sign it, you’re ready to send it to the IRS. You can either send Form 2553 by mail or by fax.
Where you mail or fax Form 2553 is determined by the state where your LLC was formed or the state where your LLC is registered to do business (if your LLC is a Foreign LLC). ddd
Please visit the following page on the IRS’s website to determine where to mail or fax Form 2553: https://www.irs.gov/filing/where-to-file-your-taxes-for-form-2553
For faster approval, fax Form 2553 to the IRS using a digital fax service such as Phone.com ($10). They have great customer support and will help you set up your digital fax in just a few minutes.
Please allow 45 to 60 days for the IRS to mail you back your S-Corp election approval letter.
If your LLC’s S-Corp election is approved you will receive a CP261 Notice.
We recommend making a few copies of the CP261 Notice and keeping them with your LLC’s records. Make some physical copies as well as some digital copies.
If your LLC’s S-Corp election is denied you will receive a CP264 Notice. You’ll then need to speak with the IRS and/or your accountant to see what the cause was and if/when you should re-file Form 2553.
If you lose your CP261 Notice, you can also call the IRS (800-829-4933) and request an “S-Corp Verification Letter”, technically known as a 385C. The CP261 can only be generated once (it’s auto-generated internally at the IRS), however the CP261 and 385C have the same effect. The 385C will arrive by mail 7 to 14 days after you call.
An S-Corporation is a “pass through” tax entity in that it doesn’t pay federal taxes at the corporate level. The profits, losses, credits, and deductions from the S-Corporation “flow through” to the individual shareholders’ (owners) personal tax return and they are responsible for paying the tax.
However, the S-Corporation still needs to file what’s known as an “informational return”. That includes filing Form 1120S as well as issue K-1s to each of the S-Corp shareholders.
For 90+% of LLCs which operate on the calendar year (Jan. 1 to Dec. 31), the S-Corp tax return will be due by March 15th each year. And like personal tax returns, if your S-Corporation needs an extension, you can file Form 7004.
There are also additional tax forms your S-Corporation must file in order to report taxes paid from payroll (withholding income tax, Social Security, and Medicare). This is filed on Form 941. And Form 940 will be used for federal unemployment tax.
The IRS is very strict about due dates and has the right to impose penalties if your S-Corp tax return is late (or missing information). If no tax is due and you need to file an informational return only the IRS can charge $195 per month per person. If there is a tax due, it’s $195 per month per person plus 5% of the unpaid tax for each month it’s late. This is just an overview though. For more info please see the “Interest and Penalties” section of Form 1120S instructions.
Calculating your S-Corporation’s tax obligations and correctly filing all IRS forms can be complicated, and if done improperly, can lead to IRS penalties, fines, and interest.
As mentioned throughout this lesson, we recommend you work closely with an accountant to make sure you file your S-Corporation taxes properly as well as keep your S-Corporation in compliance with any other IRS requirements.
Depending on the state where you formed your LLC, you may also need to file an S-Corp state-level tax return (in addition to your federal return) as well as state unemployment insurance.
Please get in contact with your state’s Department of Revenue or speak to your accountant for details.
If you currently have an LLC taxed as an S-Corp but you’d like to cancel this tax election with the IRS, this is called a “Voluntary Revocation of S-Corporation Status”.
You need to send 3 items to the IRS if your LLC wants to revoke its S-Corp status:
- Letter of Revocation of S-Corporation Election
- Statement of Consent of LLC Members for S Election Revocation
- IRS Form 8832
You can find the download links and the instructions to the above forms on this page: https://www.llcuniversity.com/irs/llc-revoke-s-corp-election/
If you have any questions regarding your LLC being taxed as an S-Corp, or how to fill out Form 2553, you can call the IRS at 800-829-4933. You can find additional IRS phone numbers at this link: https://www.irs.gov/help/telephone-assistance
IRS phone support is available from 7am to 7pm, Monday through Friday. For shorter hold time, we recommend calling earlier in the morning.
IRS: Foreign persons
IRS: United States persons and foreign persons
IRS: Retirement plan contributions based on S-Corporation distributions