Did you know you can elect S-corp status for your business, even back dating to Jan. 1st, 2020? Nabers Group provides these insights to better understand what can be the best choice for your circumstances:
- Blog post: Business Basics: Sole Proprietorship
- Business Basics: Limited Liability Company
- Business Basics: Corporations
An important advantage of an S-Corp is your ability to protect your income from a large chunk of self-employment taxes. If this is something you could have benefited from in the past, it is possible to retroactively make your S-Corp election back to January 1, 2020.
Electing S-Corp Status Retroactively is Possible
Going back to January 1, 2020 enables you to capture the benefits for 2020 and going forward. However, it is possible to go back as far as 3 years and 75 days from the date the change is requested (IRS Late Election Relief). Going back that far means you’ll need to amend your tax returns (as if the election was in place – this means making new W-2’s, too). The IRS details are in IRS Rev. Proc. 2013-30 (the meaningful portion begins with Section 2. Background .01 S Corporation Elections). That IRS procedure provides the simplified methods for taxpayers to request relief for late S-Corp elections.
In a nutshell, the IRS concludes that if your business looks and acts like an S-Corp, then you are an S-Corp. Eligibility requires:
- You must already have an LLC, partnership, or C-Corp in place.
- Your entity must be domestic.
- The entity has 100 or fewer shareholders (perfect to sponsor a Solo 401k!)
- Shareholders are individuals, estates, or exempt organizations, but cannot be non-resident alien shareholders.
- Only one class of stock (you can have voting and non-voting as one class).
There some other small details, but 99% of the LLCs, general partnerships, and C Corps already qualify. And a sole proprietor can make changes retroactive for 2020.
What is an S-Corp?
You may be just starting your business or already operating as a sole proprietor, LLC, general partnership, or even a C-Corp but don’t have an understanding of how these are different from an S-Corp. If you are operating as a less complicated entity, you might assume it will be too costly, time-consuming, or not beneficial to become an S-Corp — but this is not necessarily the case.
For IRS tax purposes, an S-Corp is treated as an income pass-through entity, much the same as a sole proprietor, LLC, or general partnership. The S-Corp also has advantages that are commonly associated with a C-Corp (especially reducing self-employment tax).
To determine if you elect S-Corp status with the IRS, an S-Corp is created by filing Articles of Incorporation with the Secretary of State or similar government body (the information required for incorporation documents vary by state). The S-Corp issues stock and is governed as a corporation, with directors, officers, and shareholders who function in the same manner as their C-Corp counterparts. You (as a shareholder) have the same protection from liability as shareholders of a C-Corp. An S-Corp shareholder’s personal assets, such as personal bank accounts, cannot be seized to satisfy business liabilities.
Unlike a C-Corp, there is no “double taxation,” meaning that the owner does not need to pay taxes twice (once at the corporate level and again on the individual shareholder level). The S-Corp passes through most of its income and loss items to the shareholders. Each shareholder is subject to his or her tax rate on the profits and losses passed through to him or her, recorded as net income on their income tax return.
You’ll have to consider your circumstances but generally, the advantages of an S-Corp are more beneficial than the disadvantages. The ability to back date electing your s-corp status to 2020 may provide a tax advantage for you.
Other advantages to electing s-corp status for your business include:
- Protecting assets. A shareholder does not have personal liability for the business debts and liabilities of the corporation. Creditors cannot pursue the personal assets (home, bank accounts, etc.) of the shareholders to pay business debts. In a sole proprietorship or general partnership, owners and the business are legally considered the same — leaving personal assets vulnerable.
- Reduce self-employment tax liability, while still generating business-expenses and wage-paid deductions for the corporation. S-Corp shareholders can be employees of the business and draw salaries as employees. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation.
- Most states pass through taxation to the individual. This again means that business losses can offset other income on the individuals’ state tax returns to reduce income tax paid.
- Simpler and tax-advantaged transfer of ownership. You can transfer interests in an S-Corp without triggering adverse tax consequences. (In a partnership or an LLC, the transfer of more than a 50% interest can trigger the termination of the entity.)
- Enhanced credibility. Corporate status can convey more credibility than other business entities with potential customers, employees, and suppliers because they see the owner has made a more formal commitment to the business.
Some businesses elect not to file as an s-corp on purpose. These businesses prefer operating as a sole proprietor, LLC, or general partnership for simplicity and possibly cost reasons. Additionally, you must consider:
- Incorporation costs and ongoing costs. At a minimum, you’ll pay fees to incorporate the business by filing Articles of Incorporation in the state of your choosing. Most states also have annual fees and other requirements such as an annual report and franchise tax fees. You can deduct these fees as a business expense. However, a sole proprietor, LLC, or general partnership doesn’t typically involve these events.
- Stock ownership restrictions are not likely to be an issue for Solo 401k businesses. However, the IRS only allows one class of investors. Additionally, there cannot be more than 100 shareholders.
- Possible limited flexibility when allocating income and loss (this is unlikely for a Solo 401k business). Because of the one-class-of-stock restriction, an S-Corp cannot easily allocate losses or income to specific shareholders. Stock ownership governs allocation of income and loss, unlike a partnership or LLC.
- Possibly more IRS oversight. The IRS more closely scrutinizes payments of dividends or salary to make sure the characterization conforms to reality. The IRS may look for an unreasonably low or zero salary as a way to avoid all self-employment tax.
- Taxable fringe benefits. Taxed as compensation to employee-shareholders who own more than 2 percent of the corporation.
You Can Elect S-Corp Status Back Dating to 2020
Determine if it’s valuable to elect s-corp status for your business, even back dating to 2020. There may be more advantages than you know. A Solo 401k with S-Corp status can be a beneficial option to help business owners contribute income towards retirement in addition to offering valuable tax deductions.
The IRS recognizes Solo 401ks adopted by S-Corps and follows the same regulations as other Solo 401ks with minor differences in contribution rules. Finally, a Solo 401k S-Corp can be relatively easy to set up and maintain without complicated forms or difficult tests to perform.