At first glance, the corporate tax rules for forming an S corporation appear simple. However, they are not. You are already aware the tax code is full of hidden rules. The IRS knows these rules and you need to know them, too. In this article, we do two things:
- We help you avoid the potholes that destroy your S corporation.
- We identify some of those rules that work to your advantage when you operate as an S corporation.
Here is what your business must look like when it operates as an S corporation (IRC Section 1361):
- The S corporation must be a domestic corporation.
- The S corporation must have fewer than 100 shareholders.
- The S corporation shareholders can be only people, estates, and certain types of trusts.
- All stockholders must be U.S. residents.
- The S corporation can have only one class of stock.
But what often appears simple on the surface is not so simple at all.
Mistakes about the Requirements
Some rules are a little hidden. If you violate one of them, your S corporation magically reverts to a C corporation, and this result could be horrible. To add to the horror, imagine if the S corporation reverts to a C corporation for not just one but three years. Here are the hidden rules that most likely apply to you.
Don’t Forget Your Spouse
If you live in a community property state, your spouse by reason of community property law may be an owner of your corporation. This can be true whether or not your spouse has stock in his or her own name.
Community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
So why should you be concerned about this?
If your spouse is an owner, your spouse has to meet all the same qualification requirements you do. This can raise two issues:
- If your spouse does not consent to the S corporation election on Form 2553, your S corporation is not valid. (Reg. Section 1.1362-6(b)(2)(i))
- If your spouse is a non-resident alien, your S corporation is not valid. (IRC Section 1361(b)(1)(C))
Converting an LLC to an S Corporation
Method 1. To convert your LLC to an S corporation for tax purposes, you can use a method we call “check and elect.” It’s easy—just two steps. First, you “check” the box to make your LLC a C corporation. Then, you “elect” for the IRS to tax your C corporation as an S corporation. Here’s how you take the two steps:
- File IRS Form 8832 to check the box that converts your LLC to a C corporation.
- Then file Form 2553 to convert your C corporation into an S corporation.
Method 2. Your LLC can skip the C corporation step and directly elect S corporation status by filing Form 2553. (Reg. Section 301.7701-3(c)(1)(v)(C))
Loans That Exterminate S Corporation Status
Don’t make a bad loan to your S corporation. With the wrong type of loan, you enable the IRS to treat that loan as a second class of stock that disqualifies your S corporation.
Small loans are okay. If the loan is less than $10,000 and the corporation has promised to repay you in a reasonable amount of time, you escape the second-class-of-stock trap. (Reg. Section 1.1361-1(l)(4)(ii)(B)(1))
Larger loans are more closely scrutinized. If you have a larger loan, your loan escapes the second-class-of- stock trap if it meets the following requirements:
- The loan is in writing.
- There is a firm deadline for repayment of the loan.
- You cannot convert the loan into stock.
- The repayment instrument fixes the interest rate so that the rate is outside your control.
You Can Have a Separate Class of Non-Voting Stock
One of the biggest complaints about S corporations is the one-class-of-stock requirement. The thing is, you can have separate classes of stock as long as the only difference between them is the voting rights of each class. (IRC Section 1361(c)(4))
For example, you can create both voting stock and non-voting stock as long as all other aspects of the stock are the same. If you want to give someone distributions (allow them to share in the profits) but not let that person have any control over business decisions, give him or her non-voting stock.
Non-voting stock can be very helpful if you want to give money to someone in a lower tax bracket, such as your retired parents.
Time of Filing Can Make a Big Difference
In general, your business needs to meet the requirements for S corporation status on the day it files the S corporation election.
Example. Suppose you want your business to be an S corporation on January 1, 2023. If you file your election in 2022 and elect January 1, 2023, as your effective date for the election, the IRS will look to see if you meet the requirements as of that 2022 day when you filed the election.
What if you want to be an S corporation but you don’t file the form before the end of the year? No problem. The tax code gives you the first two months and 15 days of the next year to file the election and have it become effective retroactively on the first day of the year.
For a calendar-year business, this means file by March 15 to make the election effective on January 1. But to file in this expanded period, you must meet the requirements for S corporation status for the entire year, even the period before you filed the election.
You also must get the consent of everyone who held stock in your corporation for that year.
Example 1. Suppose you want to convert your business to an S corporation in 2023. You can file your election as late as March 15, 2023. But your business must meet all the S corporation requirements as of January 1, 2023.
Example 2. Continuing with the example above, suppose you are in a community property state, and you get divorced in February 2023. You need your ex-spouse’s consent to the S corporation election because he or she was a shareholder in January (during the time of your marriage).
Beware of Extra Taxes for Some C Corporations
If you operated your business as a C corporation, you may face some special issues when you convert to an S corporation. These can be fairly complicated—more complicated than you want to read about now. But we have flagged these issues so you can keep an eye out for them.
- Built-in gains tax. If your C corporation’s assets are worth more than their basis, you could face some high taxes when you sell those assets.
- Loss of tax attributes. If your C corporation had loss carryover or minimum tax credits, the tax code generally does not allow them while your business is an S corporation.
- LIFO recapture. You may face a recapture tax if your C corporation used the LIFO (last in, first out) method of accounting for its inventories.
- Passive investment income. You may face a special higher tax if your previous C corporation had accumulated earnings and profits and then more than 25 percent of your S corporation’s income comes from passive investment income (generally, income from royalties, rents, dividends, interest, and annuities).
In conclusion, when making the Form 2553 election, don’t forget your spouse. In a community property state, your spouse generally is a shareholder even if your name is the only name on the stock certificate or other ownership media. Also, you convert both a C corporation and an existing LLC to an S corporation with an election on IRS Form 2553. When you make the S corporation election before you want it to become effective, you must meet all the rules for qualification on the date you filed Form 2553. If you are filing after the date, you want it to become effective, such as on March 15 for a calendar-year S corporation, you must qualify for S corporation status for the full year.
And finally, you do not violate the one-class-of-stock rule when you have voting and non-voting shares for that stock. If, upon formation of the corporation, you and other shareholders will loan the corporation money, make sure to document those loans properly. If you operated as a C corporation before converting to an S corporation, make sure to examine the built-in gains tax, loss carryover, LIFO inventory, and passive loss issues.