A corporation, or an LLC eligible to be taxed as a corporation, becomes an S corporation for federal tax purposes by filing Form 2553, Election by a Small Business Corporation. The election changes how profits are taxed and how owners are paid, so it is worth understanding before you sign.

Who can elect

The IRS describes the requirements on its S corporations page. In summary, the business must:

  • Be a domestic corporation, or an entity eligible to elect corporate treatment
  • Have only allowable shareholders: generally individuals, certain trusts and estates, but not partnerships, corporations or nonresident aliens
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation, such as certain financial institutions and insurance companies

Timing

To be effective for a tax year, Form 2553 is generally filed no more than two months and 15 days after the beginning of that tax year, or at any time during the preceding tax year. For a calendar-year business that means by March 15 for the election to apply from January 1. A newly formed company counts from the date it first has shareholders, acquires assets or begins doing business.

Every shareholder at the time of the election must consent by signing the form. Missing signatures are a common reason for rejected elections, especially where spouses in community property states also need to consent.

Late elections

The IRS provides simplified relief for late elections in many cases, when the business has reasonable cause and meets the conditions in the form instructions. Relief requests are made on Form 2553 itself, with an explanation.

LLCs electing S status

An LLC can file Form 2553 directly; it is then treated as having elected corporate classification as well. A separate Form 8832 is usually not needed.

What changes after the election

  • Payroll: owners who work in the business must be paid reasonable wages through payroll; see S corporation reasonable compensation
  • Return: the business files Form 1120-S and issues K-1s
  • Books: owner draws become distributions and must be tracked with basis
  • State taxes: some states do not follow the federal election or impose entity-level taxes

Is it worth it?

The main attraction is that distributions above reasonable wages are not subject to self-employment tax. The trade-off is payroll costs, a separate return and more administration. Our tax services team can model the numbers using your actual profit before you file.

Before you file: a readiness checklist

  • Payroll is ready: once the election is effective, shareholder-employees who work in the business generally need to be paid reasonable wages through payroll; see S corporation reasonable compensation
  • Books are clean: separate accounts for distributions and wages make compliance easier
  • All shareholders are eligible and every one of them can sign the consent
  • State treatment is checked: some states require their own election or treat S corporations differently
  • The cost-benefit is calculated: compare estimated payroll costs and added compliance with the expected savings

Key terms

Definitions for terms used in this guide, from our small business glossary:

  • Assets: Assets are resources a business owns or controls that are expected to provide future economic benefit.
  • Self-Employment Tax: Self-employment tax is the Social Security and Medicare tax paid by people who work for themselves, calculated on net earnings from self-employment.