S-Election and Business Entity Taxes

In the insurance industry, a large percentage of businesses choose to organize themselves as either C corporations or Limited Liability Companies (LLCs). Both structures, however, can take advantage of a provision in the Internal Revenue Code that allows the business to pass its income, losses, deductions, and tax credits through to the individuals controlling the entity. This provision, known as an S-election, allows filers to avoid “double” taxation of business income.

S-Election for C Corporations

A “standard” corporation pays taxes on its earnings under the General Rules of Subchapter C of the Internal Revenue Code. If the corporation then distributes those earnings to stockholders in the form of dividends, the stockholders also must pay taxes on this income as individuals.

C corporations that meet the criteria listed in Subchapter S of the IRS Code can apply for an S-election. To qualify, a corporation must:

  • Be a domestic corporation
  • Have only allowable shareholders
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation

The application is made using Internal Revenue Service Form 2553.

If the corporation incurs a loss, the shareholder can use it to offset their personal tax obligations. If there is a profit, the shareholder pays tax only once and at the individual tax rate.

The corporation must still file an annual tax return that documents the income or loss distributed to the shareholders. Additionally, it will need to pay various employment taxes including Social Security and Medicare taxes, income tax withholding, and federal unemployment tax.

S-Election for LLCs

It may seem strange that a limited liability company would want to request an S-election. An LLC is already a “pass-through” entity, and this business structure is less restrictive than the S corporation. An LLC can have any number of members, and there are fewer restrictions on who those members can be.

The main advantage involves how employment taxes are handled. An owner who draws a salary for actively working in the business has the entire earnings they receive from the LLC taxed under the Self-Employed Contributions Act (SECA). Under S corporation rules, however, the wages they receive are subject to the Federal Income Contributions Act (FICA). Other net earnings are not subject to SECA tax.

To qualify for S-election, an LLC must first choose to be taxed as a corporation by filing Form 8832 (Entity Classification Election). Once the IRS approves this election, the business can then file Form 2553 to become an S corporation.

Losing S-Election Status

A business must submit its request for S-election status in a timely manner—no later than two months and 15 days from the start of the tax year. A corporation or LLC can also lose its S-election status. The result in either case is a significantly higher tax burden. This can negatively impact the business’s financial stability or growth potential. Business leaders may also face allegations of mismanagement from shareholders or investors.

As we’ve seen, the criteria to qualify for the S-election are strict. A business that, for example, exceeds the allowed number of shareholders can forfeit its status. A shareholder may become ineligible under Subchapter S provisions. A corporation’s stock structure may change, or the company may offer some type of financial compensation that violates the single class of stock requirement.

Fortunately, the IRS now offers regulatory relief for many of the common causes of loss of S corporation status. However, the oversight or mistake that led to the revocation must be inadvertent, and the business must address any filing errors in a timely manner.

Visit our Compliance page to learn how we can help your insurance organization navigate tax filings and other obligations with ease.