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What is IRS Form 2553
When forming a new Limited Liability Company or corporation, the IRS (Internal Revenue Service) will by default select how the entity is taxed, however IRS Form 2553 allows LLCs and Corporations to elect “S” corporation status. The S corporation election is a tax designation allowed through the Internal Revenue Code (IRC Section 1362(a) that may reduce the owner’s taxable income.
Here we will go over some of the pros and cons of the S-corp election and how to file Form 2553.
Overview of Business Taxation and S-Corporations
Each business entity can be taxed differently.
Sole Proprietorships and general partnerships are regarded by the IRS as a pass-through entity. A pass-through entity is one where the business entity doesn’t pay taxes on the profits of the business. Instead, the tax burden is transferred to the owners on their personal tax returns.
Corporations are by default recognized as a “C” corporation by the IRS for tax purposes. As a C-corp, the entity pays corporate income tax on profits of the business activities. Dividends can also be distributed to owners (shareholders or members) and tax is paid on the dividends personally. This taxing of profits and dividends is commonly referred to as double taxation.
A corporation can file Form 2553 to elect “S” corporation (also known as an “S Corp” or “Subchapter S Corporation”) federal tax classification with the IRS.
While the corporation can choose two ways to be taxed, the LLC offers the most tax flexibility as they can choose to be taxed like a sole proprietorship, partnership, C-corporation (file IRS Form 8832) or S-corporation. Even as a single-member LLC, the LLC is not recognized for tax classification purposes (called a disregarded entity) which means the LLC doesn’t file a separate ta return. While this sounds a little confusing, the LLC is still an LLC and provides its owners the same liability protection. The only difference is how the income is taxed.
Like the sole proprietorship and partnership, S corporations are also pass-through entities. This means the entity doesn’t pay tax on the profits of the small business. Instead, shareholders report their share of the business’s income or losses on their personal income tax returns and the income gets taxed at the shareholders’ personal income tax rate.
Who can elect S-Corp Status?
Only a corporation or LLC can elect S-corp status with the IRS by filing Form 2553.
In order to qualify for the S-corp election there are a few requirements:
- The entity was formed in the U.S.
- Owners may be individuals, certain trusts, and estates. Partnerships, corporations or non-resident alien shareholders are not eligible.
- Have no more than 100 shareholders / members
- Have only one class of stock. All shareholders have the same privileges of ownership.
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Why is the S Corporation election important
The primary reason to elect S-corp status is to save money on self-employment taxes.
The main way the S-corp tax election can help lower taxes is because some of the profits can be sheltered from self-employment taxes. As an entity that is taxed like a sole proprietorship or partnership, all the entity’s profits are subject to self-employment taxes. Self-employment taxes include Social Security and Medicare taxes, which combined cost the owner 15.3% of the business’s profits. With an S-corp tax status, instead of having all the profits subject to self-employment taxes, some of the profits can be distributed as dividends or distributions, representing a savings of over 15%.
With a benefit like this, you would probably guess the IRS will have some rules to follow.
Basically, the most important rule is that the IRS requires an owner to take a “reasonable salary” before distributing dividends. The actual dollar amount for this reasonable salary will vary depending on the industry of the company, normal compensation of the work being done, number of hours worked, etc., but is a key way to justify the splitting of salary and distributions.
There will be additional expenses and administration for going the S-corp route, but they are usually beneficial for a company making more than $50,000 per year in profits. Be sure to check with your accounting professional to determine your actual benefit.
Step-by-step Form 2553 instructions
To learn how to fill out form 2553, start by downloading IRS Form 2553 – Election by a Small Business Corporation.
Part 1 – Election Information
Name: Enter the name of the entity exactly as it is registered with the Secretary of State.
Address: Use the mailing address of the entity. It doesn’t have to be the physical address of the business and a PO Box number is ok to use.
Item A: Employer Identification Number: An EIN is required to file the 2553 form. If you haven’t already received one, see how to register for an EIN. It takes just a few minutes and there is no cost to get one.
Item B: Date incorporated: The date of incorporation (or formation for an LLC) will be on the documents you received from the Secretary of State (or alternatively named state agency) after filing the corporation or Limited Liability Company. If you can’t find this paperwork, you can also try running a name search as most states will show this publicly and will show the date the organization was filed.
Item C: State of incorporation: Enter the state the entity was formed.
Item D: If the entity’s name or address changed after applying for the EIN, mark this box. If it has stayed the same, leave the box blank.
Item E: For a new entity, this is normally the same date as in B (Date incorporated) above since Form 2553 is supposed to be filed no later than two months and 15 days after the effective date of S-corp election in order for the changes to apply in the first tax year. If the due date has passed, there is a way to still obtain the tax status through a late filing.
Item F: Most companies will select their accounting fiscal year as a calendar year, which is January 1 – December 31. If you select box (2) or (4), then you will also complete part II below. Calendar year businesses will file their return on or around March 15th.
Item G: Not a box many will check, however there is an exception to the 100 shareholder limit rule if any of the shareholders are in the same family and want to count a family share as one shareholder (such as a husband and wife).
Item H: Enter the name, title and phone number of an officer (or member) or legal representative should the IRS need to obtain more information.
Item I: If Form 2553 is filed after the two month and 15-day window but want the S-Corp status to take effect for that current tax year, you must provide a “reasonable cause” in this section.
Item J: Enter the name and address for each shareholder.
Item K: Each shareholder must consent to the tax change by signing and dating.
Item L: The number of shares owned or percentage for each shareholder needs to be entered, along with the date it was acquired.
Item M: The social security number or Employer Identification Number for each owner is entered.
Item N: Enter the shareholder’s tax year (year the tax return is filed).
Part II – Selection of Fiscal Tax Year
If any choice other than (1) Calendar year was selected in Item F, Part II will be used to justify the different fiscal year. In addition, Form 8716, Election to Have a Tax Year Other Than a Required Tax Year will need to be filed. This form is either filed with Form 2553 or filed separately.
Part III – Qualified Subchapter S Trust (QSST) Election
Another uncommon section that won’t apply to most filers, the Qualified Subchapter S Trust (QSST) can hold ownership in an S-corp, but only by first filling out Part III.
Part IV, Form 2553 Instructions: Late Corporate Classification Election Representations
Part IV is only needed if filing after the S-corp deadline of 75 days. These are the representations that must be included in either Item I of Part I or in a separate, attached statement.
While these instructions are generally straight-forward, it’s never a bad idea to talk with a tax professional.
Where is Form 2553 filed?
Form 2553 can be filed by mail or fax as there is no online submission. The mailing address will vary depending on the state the small business is located. Current IRS mailing address – https://www.irs.gov/filing/where-to-file-your-taxes-for-form-2553
How Long Does it Take for Form 2553 to Get Approved?
Normally, it will take 45 to 60 days for the IRS to approve the S-Corp election. An approval letter (CP261 Notice) will be mailed. Be sure to keep this letter in your files.
If the election is denied, a CP264 notice will be sent. If this notice is received, review the cause of the denial and contact the IRS to see if it can be reversed.
Once the S-corp election is approved, it stays in effect until the company dissolves or changes its tax status. If terminated by the owners, it typically takes five years before being able to re-apply for S-corp status again.
Many new small business owners jump the gun and immediately file Form 2553 because they heard they will save money on taxes, when in fact they may be better off keeping their LLC in its default tax status (taxed as a Sole Proprietorship for a single-member LLC or taxed as a Partnership for a multi-member LLC) for the first few years until net income increases. This is due to the additional costs and time to administer, as now quarterly payroll taxes will need to be reported and paid on the owner, so it’s important to run the numbers to be sure the election is worth doing.