This post discusses how a corporation may make an election to be treated as an S corporation for federal tax purposes. A corporation may become an S corporation if:
(1) it meets the requirements of S corporation status;
(2) all its shareholders consent to S corporation status;
(3) it files Form 2553, Election by a Small Business Corporation, to indicate it chooses S corporation status; and
(4) it uses a permitted tax year, or elects to use a tax year other than a permitted tax year (explained below) .
All of these requirements are discussed further below.
Requirements of an S Corporation
To qualify for S corporation status, a corporation must meet all the following requirements:
(1) It must be a domestic corporation. In other words, it must be a corporation that is either organized in the United States or organized under federal or state law.
(2) It must have only one class of stock.
(3) Generally, it must have no more than 100 shareholders.
(4) It must have as shareholders only individuals, estates, and certain trusts; certain pension plans and certain charities may also be shareholders.
(5) All of its shareholders must be either citizens or residents of the United States. Nonresident aliens may not be shareholders.
One Class of Stock
“One class of stock” generally means that the outstanding shares of the corporation must be identical as to the rights of the holders in the profits and assets of the corporation. Stock may have differences in voting rights and still be considered one class of stock, if all other rights are identical. A stock purchase agreement executed between an S corporation and its shareholders that does not affect the shareholder’s rights in the corporation’s profits and assets will not create a second class of stock. Debt obligations of a corporation that are actually contributions of equity capital may be treated as a second class of stock. However, straight debt will not be considered a second class of stock. The term “straight debt” means any written unconditional promise to pay a fixed amount on demand or on a specified date, if:
(1) the interest rate and interest payment dates are not contingent on profits, the borrower’s discretion, or similar facts;
(2) the debt cannot be converted, directly or indirectly, into stock; and
(3) the creditor is an individual, estate, or trust eligible to hold stock in an S corporation; banks can also hold straight debt.
The corporation’s election of S corporation status is valid only if all shareholders consent to the election. Once made, the S election may be revoked only if shareholders who collectively own more than 50% of the outstanding shares of the corporation’s stock consent to the revocation. Shareholders may consent by providing the required information on Form 2553 and signing in the appropriate place on that form. All shareholders must consent at the time the Form 2553 is filed. If the consent is filed after the beginning of the year for which it is to be effective, all shareholders in the corporation who held stock on any day in the tax year before the date the Form 2553 is filed must also consent.
The corporation must qualify as an S corporation when it files its Form 2553. The Form 2553 should be filed with the IRS Service Center where the S corporation will file its income tax return. The election of S corporation status applies to a particular tax year if the Form 2553 is filed:
(1) any time during the previous tax year; or
(2) by the 15th day of the third month of the tax year.
A “late” or invalid election can cause adverse tax consequences. Extreme care should be exercised to ensure that the Form 2553 is accurately completed and filed in a timely manner. Although the IRS may treat a late or invalid election as timely and valid if reasonable cause is shown, it is far preferable to ensure that the requirements are met.
A permitted tax year is a calendar year or any other accounting period for which the corporation establishes a business purpose to the IRS’s satisfaction. In addition, an S corporation may elect under §444 of the Internal Revenue Code to have a tax year other than a permitted tax year. A corporation electing S corporation status does not need the IRS’s approval to choose a calendar year as its tax year. An electing S corporation should use Form 2553 to request a tax year other than a calendar year or to make the §444 election.
If your corporation needs assistance making the election to be taxed as an S corporation contact Paul by clicking here.