Business owners sometimes reconsider how their company is taxed as the business grows. One option that may be available to an eligible business is an S corporation election, which can provide pass-through federal tax treatment and may offer tax advantages in certain circumstances.

Making the election, however, is not simply a matter of checking a box. The business must meet specific eligibility requirements, obtain the necessary shareholder consents, and file Form 2553, Election by a Small Business Corporation, within the applicable deadline.

Here is what business owners should know before making an S corporation election.

What Is an S Corporation Election?

An S corporation is a corporation—or another eligible entity that has elected to be treated as a corporation—that chooses special federal tax treatment under Subchapter S of the Internal Revenue Code.

Generally, an S corporation passes its income, deductions, gains, losses, and credits through to its shareholders. Shareholders generally report their share of these items on their individual tax returns.

This pass-through structure can help an eligible business avoid the traditional corporate-level federal income tax followed by shareholder-level taxation on dividends that can occur with a C corporation. However, S corporations can still be subject to certain federal taxes at the entity level.

An S corporation election should therefore be evaluated based on the business's complete tax and financial situation rather than assuming it will automatically reduce taxes.

Who Can Make an S Corporation Election?

A corporation or another eligible entity that can elect to be treated as a corporation may generally make an S corporation election if it meets the applicable requirements.

The IRS generally requires an S corporation to:

·         Be a domestic corporation or an eligible domestic entity.

·         Have no more than 100 shareholders.

·         Have only allowable shareholders, such as individuals, certain trusts, estates, and certain tax-exempt organizations.

·         Have no nonresident alien shareholders, subject to specific statutory exceptions.

·         Have only one class of stock.

·         Not be an ineligible corporation, such as certain financial institutions, insurance companies, or domestic international sales corporations.

·         Meet applicable tax-year requirements.

·         Obtain the required shareholder consents.

The source article states that a business must have “less than 100 shareholders.” The IRS rule is more precisely no more than 100 shareholders.

Who Files Form 2553?

Form 2553 is used to make the S corporation election under Section 1362(a).

A corporation or eligible entity seeking S corporation treatment generally files Form 2553 with the IRS. The election requires the appropriate shareholder information and consents.

For example, an LLC may potentially make an S corporation election if it is an eligible entity. An LLC does not necessarily have to become a state-law corporation simply because it elects S corporation tax treatment.

The IRS explains that an eligible entity may elect to be treated as a corporation and then make the S corporation election, provided it satisfies the applicable requirements.

What Should You Do Before Filing Form 2553?

Before making an S corporation election, review the company's legal and tax structure carefully.

Important areas to consider include:

1. Confirm eligibility

Review the ownership structure, shareholder residency, number of shareholders, stock structure, and type of business.

An otherwise eligible business can lose S corporation eligibility if it has a prohibited shareholder or violates other requirements.

2. Review corporate and operating documents

The company's formation documents, bylaws, operating agreement, shareholder agreements, and other governing documents should be reviewed for consistency with the intended ownership and distribution structure.

The IRS considers governing provisions—including corporate documents and certain binding agreements—when determining whether a corporation has only one class of stock. Generally, the shares must provide identical rights to distributions and liquidation proceeds.

This does not mean every LLC must amend its operating agreement simply to state that it wants S corporation tax treatment. The important consideration is whether the governing documents and actual ownership arrangements are consistent with S corporation requirements.

3. Review the tax consequences

An S corporation election can change how the business reports income and compensates owners.

For example, an owner who performs services for an S corporation generally needs to be treated as an employee and receive reasonable compensation through wages before certain non-wage distributions are considered.

The election therefore creates additional payroll and compliance responsibilities that should be considered alongside any potential tax benefits.

What Information Is Included on Form 2553?

Form 2553 collects information the IRS needs to process the S corporation election.

The form generally asks for information such as:

·         Corporation or entity name and address

·         Employer Identification Number (EIN)

·         Date the business was incorporated or formed

·         Requested effective date of the S corporation election

·         Tax year information

·         Shareholder information

·         Ownership percentages and shares

·         Shareholder consent

·         Officer or authorized representative information

·         Information relating to certain trusts, when applicable

·         Explanations and information required for certain late elections

Form 2553 contains four parts:

Part I — Election Information:Provides the basic information needed to make the S corporation election and includes shareholder consent information.

Part II — Selection of Tax Year:Addresses the corporation's tax year and related requirements.

Part III — Qualified Subchapter S Trust (QSST) Election:Applies when the election involves a qualifying trust.

Part IV — Late Election Information:Used when requesting relief for a late S corporation election.

Not every business will need to complete every part of the form.

What Happens If You Do Not File Form 2553?

A business does not automatically become a C corporation simply because Form 2553 was not filed.

The default federal tax classification depends on the type of entity and its ownership. For example, an eligible single-member LLC may generally be treated as a disregarded entity, while a multi-member LLC may generally be treated as a partnership unless an election is made to change its federal tax classification.

For an entity that otherwise would qualify for S corporation treatment, failing to make a timely S election generally means the S corporation election will not be effective for the intended tax year.

This distinction is important because the source article's statement that the IRS will automatically categorize every business that does not file Form 2553 as a C corporation is too broad.

When Is Form 2553 Due?

Timing is one of the most important parts of making an S corporation election.

Generally, Form 2553 must be filed no more than 2 months and 15 days after the beginning of the tax year for which the election is intended to take effect. The election can also generally be filed at any time during the preceding tax year for the following tax year.

For a calendar-year business seeking S corporation treatment beginning January 1, the standard deadline is generally March 15.

If March 15 falls on a weekend or legal holiday, the applicable filing deadline generally moves to the next business day.

The source article's reference to the “16th day of the third month” is therefore not the clearest way to explain the current general rule. The IRS describes the deadline as 2 months and 15 days after the beginning of the tax year.

Can You File Form 2553 Late?

Missing the deadline does not necessarily mean the business can never obtain S corporation status.

The IRS provides procedures for requesting late-election relief in qualifying circumstances. A business generally needs to satisfy the applicable requirements and provide the required explanation for why the election was not timely filed.

Late-election relief should not be assumed to be automatic. The circumstances and requirements should be reviewed carefully before relying on a late election.

How Do You Submit Form 2553?

Form 2553 has traditionally been submitted to the IRS by mail or fax, using the appropriate filing address or fax number for the taxpayer's location.

The IRS also provides procedures for certain corporations changing their filing status from C corporation to S corporation to submit Form 2553 as a PDF attachment with a timely electronically filed return, while still requiring the paper/fax filing process described by the IRS for the election.

Because filing procedures and IRS addresses can change, taxpayers should check the current Form 2553 instructions before submitting the election.

Does Form 2553 Change the Business's Legal Structure?

Not necessarily.

An S corporation election is primarily a federal tax election. For example, an eligible LLC can elect S corporation taxation while continuing to exist as an LLC under state law.

The election changes how the entity is treated for federal tax purposes; it does not automatically mean that an LLC must be legally converted into a corporation under state law.

What Happens After the S Corporation Election?

Once an S corporation election is accepted and becomes effective, the business generally has additional tax and payroll responsibilities.

An S corporation generally files Form 1120-S, U.S. Income Tax Return for an S Corporation, and provides shareholders with Schedule K-1 information reflecting their share of the company's tax items.

Owners who work for the company may also need to be treated as employees, which means the business must handle payroll, employment taxes, and appropriate wage reporting.

These requirements make S corporation status more complex than simply changing the tax classification on paper.

Final Thoughts

Form 2553 is an important document for businesses seeking S corporation tax treatment. Before filing, owners should confirm that the company qualifies, review its ownership and governing documents, understand the tax and payroll implications, and make sure the election is submitted by the applicable deadline.

For many businesses, an S corporation election can be worth considering. But the potential benefits should be weighed against payroll requirements, administrative costs, shareholder restrictions, and ongoing tax compliance.

Contnow Tax Preparation LLC can help business owners evaluate their S corporation election, prepare the information needed for Form 2553, and understand the tax and compliance responsibilities that follow the election.

 

 

 

 

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