For entrepreneurs who are incorporating their business, taxation will likely be a major issue. While many business owners may not have heard of IRS Form 2553, this form could be the key business owners need to avoid double taxation. In some instances, a corporation effectively gets taxed twice, once on its profits and again on the dividends paid out to shareholders. Form 2553 helps corporations avoid this double taxation, but only certain companies are eligible and an application must be made soon after incorporation.
For many regular corporations, profits can be taxed at up to 35 percent. Furthermore, even though those profits may be paid out as dividends to shareholders, the corporation receives no deduction for those dividends. When the shareholders receive those dividends, they too must pay tax on them, despite the corporation itself having effectively already paid tax on the dividend as part of its corporate tax rate. In effect, the corporation’s profits get taxed twice.
Nobody likes paying taxes twice, which is why Form 2553 can be such a useful tool. This form allows eligible companies to apply for S-corporation status. S-corporation status is important because it allows corporations to pay out all of their income as dividends to shareholders. While the shareholders must still pay tax on those dividends, the corporation itself manages to avoid paying corporate tax on its profits. In effect, S-corporation status allows companies to avoid what would otherwise be double taxation.
Who is eligible?
Not all corporations are eligible for S-corporation status nor is S-corporation status even desirable for all businesses. An eligible corporation must have only one class of stock and the corporation must have a maximum of 100 shareholders. In most cases, shareholders must be individual persons and not corporate entities, although exceptions are made for trusts and estates. Shareholders cannot be nonresident aliens. Furthermore, the corporation must notify the IRS of its intention to be pursue S-corporation status by the 15th day of the third month following the date of incorporation. However, there are instances when corporations can make a late application for S-corporation status.
Are there alternatives?
The truth is, however, that while S-corporation status has tax benefits, these benefits are not quite as attractive as they used to be. Limited liability companies (LLC) nowadays offer many of the benefits of incorporation with taxation options that are similar to S-corporation status. Furthermore, LLCs tend to be less regulated than S corporations. One potential benefit of an S corporation compared to an LLC, however, is that LLC owners pay self-employment taxes on all of the income generated by their company. The owner of an S corporation, by contrast, can pay themselves “reasonable compensation,” which may be only a fraction of the corporation’s profits. The employment tax will apply only to the “reasonable compensation” rather than to all of the corporation’s profits.
S-corporation status can be an attractive route for some companies looking for a tax break. A corporate lawyer can help business owners determine whether completing Form 2553 could be beneficial for their business.