How to Elect to be Taxed as an S-Corporation
Understand the implications of an S-corp tax election. This guide details the formal process and ongoing responsibilities for business owners.
An S corporation election is a tax classification that allows a business to be taxed under Subchapter S of the Internal Revenue Code. This is a choice made by an existing corporation or a limited liability company (LLC). The benefit of this election is pass-through taxation, which allows profits, losses, and deductions to pass directly to the owners’ personal tax returns. This structure avoids the double taxation that affects C corporations, where income is taxed first at the corporate level and again when distributed to shareholders.
Eligibility for S Corporation Status
To qualify for S corporation status, a business must be a domestic corporation or an eligible domestic entity like an LLC, meaning it is organized within the United States. The entity must adhere to limitations on its ownership structure.
A requirement is the limitation on the number of shareholders. An S corporation can have no more than 100 shareholders, which prevents large, widely-held corporations from using this tax status. For the purpose of this count, members of a family can be treated as a single shareholder.
The type of shareholder is also restricted. Allowable shareholders include individuals, certain trusts, and estates. Partnerships and corporations are prohibited from being shareholders, and non-resident aliens are not permitted to hold shares.
Finally, the corporation must have only one class of stock. This means that all issued shares must have identical rights to distribution and liquidation proceeds. While all shares must confer the same economic rights, differences in voting rights are permissible, which allows for flexibility in management.
Preparing to File the Election
The request to be taxed as an S corporation is made by filing Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service (IRS). Before filing, a business must have its legal name, mailing address, and its Employer Identification Number (EIN), which is a unique nine-digit number assigned by the IRS for tax purposes. You will also need the date and state of incorporation.
The form requires you to specify the tax year for which the election is to become effective. A central part of the form is the shareholder consent statement. Every individual who is a shareholder at the time of the election must consent by listing their name, address, Social Security Number or Taxpayer Identification Number, and the number of shares they own. Each shareholder must personally sign and date the form to validate the consent.
The timing of the filing is governed by deadlines. To be effective for the current tax year, Form 2553 must be filed no later than two months and 15 days after the beginning of that tax year. For a business using a calendar year, this deadline is March 15. The election can also be made at any time during the preceding tax year for the following year.
The Filing Process for Form 2553
Once Form 2553 is completed and signed by all shareholders, it must be submitted to the IRS. The form can be mailed to the specific IRS service center for the state where the corporation’s principal business is located. In some cases, filing by fax is a permissible alternative. The IRS provides a list of addresses and fax numbers in the form’s instructions, and you should retain the fax confirmation as proof of filing.
After submitting the form, the business should expect a response from the IRS. Within 60 days of filing, the IRS will send a notification letter, such as a CP261 notice, confirming the acceptance of the S corporation election. If no communication is received within this timeframe, it is advisable to contact the IRS to verify the status.
Should a business miss the filing deadline, it may be possible to obtain late election relief. To do so, the corporation must file the completed Form 2553 and attach a statement explaining the reasonable cause for the failure to file on time. The IRS provides revenue procedures that outline the requirements for obtaining this relief without a formal private letter ruling request.
Maintaining S Corporation Status
After the S corporation election is approved, the business must adhere to ongoing compliance requirements. A primary obligation involves paying reasonable compensation to shareholder-employees. Any shareholder who provides more than minor services to the corporation must be paid a salary that reflects the fair market value of those services, comparable to what similar businesses would pay.
Because a salary must be paid, the S corporation is required to manage payroll. This involves withholding federal income taxes, Social Security, and Medicare (FICA) taxes from the shareholder-employee’s wages. The corporation must also pay the employer’s share of these payroll taxes and file regular payroll tax returns, such as Form 941.
It is important to distinguish between salary and distributions. A salary is compensation for services rendered and is subject to payroll taxes. Distributions are payments of the company’s profits to shareholders based on their ownership percentage and are not subject to payroll taxes. Paying distributions without a reasonable salary is a compliance risk that can lead to the recharacterization of distributions as wages by the IRS, resulting in back taxes and penalties.
The business must also continuously meet all the initial eligibility criteria for S corporation status. An inadvertent termination can occur if, for example, shares are transferred to an ineligible shareholder like a corporation or a non-resident alien. This would cause the business to lose its S corp status.