Starting a business is exciting, but it comes with all kinds of decisions to make. On the tax front, many entrepreneurs have never heard of Form 2553, but this IRS form can end up giving you one of the most valuable tax breaks you'll ever have. Let's take a look at Form 2553 and discover why it's so important.
Form 2553: Opening the door to S-corporation status
No one likes to pay taxes, but business owners who form corporations can end up getting taxed not once, but twice. Regular corporations pay corporate tax of up to 35% at the entity level, without getting any deduction for dividends paid out to their shareholders. In turn, shareholders who receive those dividends pay a second layer of tax, with the amount depending on what tax bracket the individual shareholder happens to be in during the year in which the corporation pays the dividend.
Fortunately, there's a way for entrepreneurs to get the asset protection that corporations offer while avoiding double taxation. By incorporating as an S corporation, all of the income the business generates gets passed directly to shareholders, avoiding corporate tax, and leaving just a single layer of taxable profits. That's where Form 2553 comes in, as it's the form that lets you formally declare your business to be an S corporation. If you qualify, all you have to do is complete the form, and your election generally takes effect once the IRS accepts it -- typically within 60 days of your filing the form.
Are you eligible to file Form 2553?
In order to use Form 2553, your business has to be eligible to be treated as an S corporation. Specifically, the company can have only one class of stock, and no shareholders can be nonresident aliens. With the exception of certain tax-exempt organizations, as well as trusts and estates, shareholders must be individuals rather than corporate entities. The S corporation must have 100 or fewer different shareholders, although spouses are automatically treated as one shareholder, and families can elect to aggregate their interests to get single-shareholder treatment.
Also, keep in mind that some states won't recognize the federal Form 2553 for state-tax purposes. You might also have to file an appropriate form with the state's revenue department in order to comply with state law and get the benefits of S corporation status at that level.
Why Form 2553 isn't as important as it used to be
In the past, corporations were the only business entities that provided asset protection from creditors, and so S corporation status was the only tax-friendly way for entrepreneurs to protect themselves financially. But the rise of the limited liability company has made S corporations less popular, as LLCs also qualify for the pass-through taxation treatment that initially made S corporations so attractive. At the same time, LLCs have fewer limitations than the S corporation regulations have, and in most states, both offer similar levels of liability protection to their owners.
However, there are certain advantages of S corporations over LLCs. One of the biggest is that, while LLC owners have to pay self-employment taxes on the full amount of income, S corporation owners can instead establish "reasonable compensation" for their services, and avoid employment taxes on the remainder of the business' profits.
Filing Form 2553 might seem like an added burden, but for many entrepreneurs, it's the best way to save on taxes while giving themselves the financial protection they need. If you want to get S corporation status, take a closer look at Form 2553 today.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.