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 granted 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 S-corp election’s pros and cons and how to file Form 2553.
Overview of Small Business Taxation and S-Corporations
Each business entity can be taxed differently.
The IRS regards sole proprietorships and general partnerships as a pass-through entity. A pass-through entity is one where the business entity doesn’t pay taxes on the business’s profits. Instead, the tax burden is transferred to the owners on their personal tax returns.
By default, corporations are recognized as “C” corporations by the IRS for tax purposes. As a C-corp, the entity pays corporate income tax on the profits from 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 an “S” corporation (also known as an “S Corp” or “Subchapter S Corporation”) federal tax classification with the IRS. Alternatively, form 8832 can change the tax classification to the C Corporation, partnership, or disregarded entity.
While the corporation can choose two ways to be taxed, the LLC offers the most tax flexibility and be taxed like a sole proprietorship, partnership, C-corporation, 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 tax return. While this sounds a little confusing, the LLC is still an LLC and provides its owners with the same liability protection. The only difference is how the income is taxed.
Like sole proprietorships and partnerships, 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.
There are a few requirements to qualify for the S-corp election:
- 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 for electing S-corp status is to save money on self-employment taxes.
The S-corp tax election can help lower taxes for a small business by sheltering some profits 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 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 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.
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 company’s industry, normal compensation for the work being done, number of hours worked, etc., but it 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 entity’s mailing address. It doesn’t have to be the business’s physical address, 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 similarly 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 the date the organization filed.
Item C: State of incorporation: Enter the state in which 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 usually 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 entity’s effective date. If the due date has passed, there is still a way to obtain the tax status through a late filing.
Item F: Most companies will select their accounting fiscal year as a calendar year, January 1 – December 31. If you choose box (2) or (4), you will also complete part II below. Calendar year businesses will file their return on or around March 15.
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 wants 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 ad dating.
Item L: The number of shares owned or percentage for each shareholder needs to be entered as 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 (the 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 would justify the different fiscal year. Also, Form 8716, Election to Have a Tax Year Other Than a Required Tax Year, will need to be filed. This form is either submitted with Form 2553 or filed separately.
Part III – Qualified Subchapter S Trust (QSST) Election
Another uncommon section that won’t apply to most filers is that 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 straightforward, 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 in which 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?
Typically, 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.
Final Thoughts
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 reapplying for S-corp status again.
Many new small business owners jumped the gun and immediately filed Form 2553 because they heard they would save money on taxes. Often, 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. The additional costs and administration of quarterly payroll taxes may outweigh any tax savings. It’s essential first to check any state tax impacts with the Department of Revenue and work with your accountant to run the numbers and be sure the election is worth doing.