Many small business owners opt to incorporate their business and then elect to have their corporation taxed as what is referred to as an “S corporation” (named for Subchapter S of the Internal Revenue Code — the regulation that allows this type of taxation). Being taxed as an S corporation (S corp) provides the shareholders with certain tax planning advantages.
How to make an S corporation election
An S corporation is not a separate entity for federal (and most states) income taxes. Its income, losses, and tax deductions are passed through to the shareholders. Also, operating as an S corporation provides owners with an opportunity to receive income from the business as both dividends and compensation, which provides the ability to reduce the owner’s overall tax liability.
If the shareholder does not elect to be taxed as an S corporation, the corporation will be a separate taxable entity and will pay taxes on its income. (This is referred to as being taxed as a C corporation — named for Subchapter C of the IRC.)
You don’t actually form an S corporation. You just form a corporation.
You form your corporation by choosing a state of incorporation, filing articles of incorporation, and appointing a registered agent in that state. When you incorporate you don’t tell your state of incorporation that your corporation will be an S corporation. That is a tax matter only. It’s the Internal Revenue Service and state tax departments that are concerned with how you choose to have your corporation taxed — not the Secretary of State (or other corporate filing office).
And although it is referred to as being taxed as an S “corporation”, corporations are not the only entities that can elect to be taxed this way. LLCs are also eligible to elect to be taxed as an S corporation.
However, an LLC that chooses to be taxed as an S corporation is still an LLC. This election only affects the way it is taxed, not the kind of entity it is. If you have formed an LLC for your business, you may wish to discuss the pros and cons of this strategy with your accountant.
Don’t make these mistakes when incorporating or issuing shares
Not every corporation is eligible to be an S corporation. When you form your corporation, it is essential that you do not make choices that will prevent you from electing S corporation status. The critical decisions that could preclude an election are creating more than one class of stock and issuing shares to prohibited shareholders.
When drafting and filing your articles of incorporation, it is essential that you only provide for one class of stock — although shares can differ with respect to voting rights.
Other than that, the rights attached to each share, such as distribution and liquidation, must be identical. If you want to make an S corporation election down the road, you cannot authorize common and preferred shares.
There are also limitations on the shareholders themselves. Stock can only be issued to individuals who are U.S. citizens or resident aliens, and certain types of trusts and estates. Stock cannot be issued to non-resident aliens, trusts (other than those specifically allowed by the Internal Revenue Code), partnerships, and corporations. Finally, there cannot be more than 100 shareholders, although certain shareholders (such as spouses) can count as one person for the 100 shareholder limitation.
Once your corporation is officially on record with your incorporation state, the next step is to make an election to be an S corporation by filing the appropriate paperwork with the IRS.
Act quickly to make a first-year election
When you first form your corporation, you have a short window of opportunity to make an S corporation election that is effective for the first year of operation. The election must be filed with the IRS no more than two months and 15 days after the beginning of your corporation’s tax year.
If you miss filing during this period, then you have two choices: petition the IRS for a waiver of the rule or have the election take effect starting in the next tax year.
The rules for calculating the filing period are a bit tricky. The two-month period begins on the day of the month your tax year begins and ends with the close of the day before the numerically corresponding day of the second calendar month following that month.
An S corporation will usually have the calendar year as its tax year. But the first tax year will nearly always be a short tax year that begins on a date other than January 1 and ends on December 31. This first tax year starts on the earliest of the following dates: the date the corporation first had shareholders, the date it first had assets, or the date it began doing business.
Example: A corporation begins its first tax year on January 7. The first two months of the corporation’s tax year end on March 6. The 15th day of the third month in the corporation’s tax year is March 21. The narrow time window to elect S corporation status for the first year begins on January 7 and ends on March 21 (the 15th day of the third month of the corporation’s tax year). Because the corporation had no prior tax year, an election made before January 7 will not be valid.
File Form 2553 to elect S corporation status
In order to become an S corporation, the corporation must submit a completed Form 2553 (Election by a Small Business Corporation) that has been signed by all the shareholders. The following information must be provided:
- Corporation information: name, address, Employer Identification Number, date and state of incorporation
- The tax year when the election will take effect
- The corporation’s tax year
- An election to treat family members as one shareholder in order to stay under the 100 shareholder requirement
- A contact person for the IRS (usually a corporation officer or the corporation’s legal representative)
- Shareholder information: name, address, social security number, number of shares owned or percentage owned, date shares were acquired, and shareholder’s tax year
- Signatures of each shareholder.
The form also provides a way to select a tax year and to certify certain trusts qualify as shareholders.
Once the information is complete, the form is mailed (or faxed) to the IRS. (The address varies depending upon where the principal office of your business is located.) You can also use certain private delivery services designated by the IRS. Then the waiting begins. You generally will know the response within 60 days from the time the IRS receives the application.