How to Choose a Corporation Classification

A business’s legal structure under state law is a distinct concept from its classification for federal income tax purposes. When an entrepreneur forms a corporation with their state, they create a legal entity separate from themselves. This formation provides benefits, such as liability protection, which shields personal assets from business debts and lawsuits. However, this initial step does not determine how the business’s profits will be taxed by the federal government.

The Internal Revenue Service (IRS) provides different tax classifications, and the choice a business makes has long-term financial consequences. This classification dictates whether the corporation itself pays income tax or if the profits and losses are passed directly to the owners’ personal tax returns. Understanding this distinction is a part of strategic business planning, as the tax structure impacts everything from annual tax payments to the ability to attract investors and distribute earnings.

The Default C Corporation Classification

When a business is legally incorporated under state law, the IRS automatically assigns it a default tax classification known as a C corporation, named after Subchapter C of the Internal Revenue Code. As a C corporation, the business is treated as a completely separate taxpayer from its owners, or shareholders. This means the corporation is responsible for its own tax liabilities and must file its own income tax return, Form 1120, “U.S. Corporation Income Tax Return.”

The defining characteristic of a C corporation is its method of taxation, often referred to as “double taxation.” The first layer of tax occurs at the corporate level. The corporation calculates its net income and pays tax on those profits at the flat 21% federal corporate income tax rate. This tax is paid by the corporation directly to the government before any profits are distributed to its shareholders.

The second layer of tax occurs when the corporation distributes its after-tax profits to its shareholders in the form of dividends. These dividend payments are considered personal income for the shareholders, who must then report this income on their individual tax returns. Shareholders pay tax on these dividends at their applicable personal income tax rates.

Consider an example: a C corporation earns $100,000 in profit. It first pays corporate income tax at the 21% rate, which amounts to $21,000. The remaining $79,000 is now available to be distributed to shareholders. If the corporation distributes the entire amount as dividends, the shareholders receive this $79,000 and must report it as income, paying taxes on it based on their personal tax brackets. This structure is the automatic standard unless the business takes specific action to elect a different tax status.

Eligibility for S Corporation Status

A business can avoid the default C corporation tax structure by electing to be treated as an S corporation, named after Subchapter S of the Internal Revenue Code. This election changes how the business is taxed, but it is only available to corporations that meet a set of IRS requirements. Failure to meet any of these criteria at any point will result in the termination of the S corporation status.

A primary restriction relates to the number and type of shareholders. An S corporation can have no more than 100 shareholders. Furthermore, all shareholders must be individuals, certain trusts, or estates. Other corporations, partnerships, and non-resident alien individuals are prohibited from being shareholders.

Another limitation involves the type of stock the corporation can issue. An S corporation is permitted to have only one class of stock. This means that all shares must have identical rights to distribution and liquidation proceeds. While there can be differences in voting rights between shares, the economic rights of all shares must be the same, which prevents complex capital structures.

The benefit of meeting these requirements and electing S corporation status is the avoidance of double taxation. An S corporation is a pass-through entity, so its profits and losses are not taxed at the corporate level. Instead, these financial results are passed directly to the shareholders, who report their share of the income or loss on their personal tax returns.

Choosing Corporate Taxation for Other Entities

Entities not legally formed as corporations, such as Limited Liability Companies (LLCs) and partnerships, have flexibility in how they are treated for federal tax purposes. Under IRS “check-the-box” rules, these eligible entities can elect to be taxed as a corporation. An LLC, for example, remains an LLC legally but can choose to be taxed as either a C corporation or an S corporation.

To make this election, the business must file Form 8832, “Entity Classification Election,” to change its default tax classification. The default for a multi-member LLC is partnership taxation, and for a single-member LLC, it is a disregarded entity taxed like a sole proprietorship. Completing Form 8832 requires providing the entity’s legal name, Employer Identification Number (EIN), and address, and indicating the type of election being made.

If an LLC elects to be taxed as a C corporation, it will be subject to the double taxation rules. To be taxed as an S corporation, an LLC must meet all S corporation eligibility requirements. It must also follow a two-step filing process.

How to File for a New Classification

Filing for a new classification requires submitting the correct forms to the IRS, and the process is time-sensitive. The specific form and procedure depend on the election being made.

For a corporation choosing to be taxed as an S corporation, the business must file Form 2553, “Election by a Small Business Corporation.” To be effective for the current tax year, this form must be filed by the 15th day of the third month of that tax year. For a calendar-year corporation, this deadline is March 15. The completed form must be mailed or faxed to the IRS service center designated for the state where the business is located.

For an LLC or partnership electing to be taxed as a corporation, the process involves filing Form 8832, “Entity Classification Election.” The timing for this form is flexible, as the election can be effective on the date specified on the form, which can be up to 75 days before the filing date or up to 12 months after. If an LLC seeks S corporation status, it must first file Form 8832 to be taxed as a corporation and then file a timely Form 2553.

After submitting either form, the business should wait for a response from the IRS. The IRS will send a confirmation letter, usually within 60 to 90 days of receiving the election. This letter serves as notification that the new tax classification has been approved. If a business does not receive a response within this timeframe, it should follow up with the IRS.