Winning The S Corporation Election
Many small businesses and start-up entrepreneurs consider using the S corporation as the entity of choice for running their business. The formation, management, and functioning of an S corporation is the same as, or very similar to, the formation of a C corporation. The primary difference between the S corporation and its sibling, the C corporation, is the way in which the shareholders elect to have the income of the corporation taxed.
Rather than having the income of the corporation taxed at the corporate level, all of the income of the S corporation “flows through” to the shareholders of the corporation and is then taxed at the shareholder level on their individual income tax returns. However, a C corporation cannot just automatically decide to become an S corporation. Just as a candidate for an elective office must “tow the line” in order to gain the winning number of votes, the shareholders of the S corporation must adhere to the rules prescribed by the Internal Revenue Code and the Treasury Regulations in order to elect and maintain the S corporation status.
1. What is an S corporation? An S corporation is a corporation, or an organization that has elected to be treated as a corporation for tax purposes, that (i) is eligible to elect S corporation status and (ii) whose shareholders have all consented in writing to have the corporation elect S corporation status.
2. How is an S corporation formed? Generally, an S corporation is incorporated, just like a C corporation, by filing Articles of Incorporation with the Secretary of State, pursuant to the state’s incorporation statutes. Once the corporation has been formed under state law, and if the corporation is eligible to elect S corporation status, the shareholders of the corporation may elect to have the corporation treated as an S corporation for the purposes of federal income taxation.
3. What requirements must a corporation satisfy in order to be eligible to elect S corporation status? In order to elect S corporation status, a corporation must satisfy the following requirements:
- 1) There must be 75 or fewer shareholders (a husband and wife are counted as a single shareholder).
- 2) The corporation must be a domestic corporation that is organized under the laws of any state or U.S. territory.
- 3) Shareholders may only be individuals, estates or certain trusts – partnerships and corporations cannot be shareholders.
- 4) All shareholders must either be U.S. citizens or residents of the U.S.
- 5) The corporation can have only one class of stock.
4. Will the 75 shareholder limitation be violated if there are 76 individuals who own stock, but two of the shareholders are husband and wife? For the purposes of S corporation status, a husband and wife who are both shareholders in the corporation will be treated as a single shareholder. However, if the husband and wife subsequently divorce with both of them still owning separate shareholder interests in the corporation, the divorce will result in two separate shareholders for purposes of the 75-shareholder limitation.
5. May a resident alien be a shareholder in an S corporation? A resident alien (e.g. a non-U.S. citizen residing in the United States) may be a shareholder in an S corporation. However, a corporation that has a non-resident alien as a shareholder may not qualify for S corporation status.
6. What is meant by the requirement that the corporation can have only one class of stock? A qualifying S corporation may not have more than one class of stock issued and outstanding. The outstanding shares must be identical in regards to the rights of the shareholders to share in the profits and assets of the corporation. In other words, each share of stock must confer identical rights with respect to the shareholder’s right to receive dividends and distribution of remaining assets upon the liquidation of the corporation.
7. What is an example of different classes of stock? The best example of different classes of stock is common stock and preferred stock. Generally, ownership of a share of preferred stock grants the shareholder the right to receive distributions of dividends prior to any distribution of dividends to common shareholders, and upon liquidation of the corporation, to receive a return of the preferred shareholder’s capital investment prior to any distribution of remaining corporation assets to the common shareholders. Because the preferred shareholders possess different profit-sharing and liquidation rights than the common shareholders, the preferred shareholders are a separate class of stock.
8. Do the S-corporation rules allow any differences in stock ownership? For example, what if the shareholders agree to different voting rights? Differences in voting rights between various shares of stock are permitted and will not disqualify a corporation for S corporation status. Examples of different voting rights would include disproportionate voting, cumulative voting, and restrictions on a shareholder’s right to vote on corporate matters.
9. Will a Buy-Sell Agreement violate the “one-class of stock” requirement? Buy-sell agreements and redemption agreements that restrict a withdrawing shareholder’s ability to transfer his or her stock, or obligate the withdrawing shareholder to sell his or her stock to either the corporation or the remaining shareholders for a set price, are generally disregarded in determining whether the corporation has a single class of stock.
10. How do the shareholders elect S corporation status? The election of S corporation status is made on Form 2553, “Election by a Small Business Corporation” and filed with the IRS Service Center where the corporation files its corporate federal income tax return. The election of the S corporation status must be unanimously approved by all of the shareholders, as evidenced by having all of the shareholders sign the Form 2553. If a shareholder lives in a community property state, the shareholder and the shareholder’s spouse must both sign the Form 2553, even if the shareholder’s spouse does not own any ownership interest in the corporation.
11. When should the Form 2553 be filed? The Form 2553 must be filed on or before the 15th day of the 3rd month of the corporation’s tax year in order for the election to be effective as of the beginning of that tax year. A corporation that is on a calendar tax year must file the Form 2553 on or before March 15th in order for the election to be effective for that tax year.
12. How is the federal income taxation of an S corporation different from a C corporation? In a C corporation, all income, deductions, gains, and losses of the corporation are accumulated at the corporate level. The C corporation must then pay federal income tax on the C corporation’s net income and gains, leaving an amount referred to as “net income after taxes”. If the C corporation makes dividend distributions to its shareholders, each shareholder must report the amount of dividends received on his or her individual tax return, and such dividend income will be taxed once more at the shareholder level. Since the net income and gains of the C corporation are reduced by taxes at both at the corporate level and at the shareholder level, C corporations are subjected to what is commonly referred to as “double taxation”.
In contrast, the tax reporting of an S corporation is similar to the tax reporting of a partnership. An S corporation does not pay income tax at the corporate level. Instead, all of the income, deductions, gains and losses of an S corporation are divided among, and passed through to, the shareholders of the S corporation. Each shareholder is allocated a portion of each item of income, deduction, gain and loss in accordance with such shareholder’s respective ownership interest in the corporation. Each shareholder must then report their allocated share of the corporate income and deductions on their own individual income tax returns. Because there is no taxation at the corporate level, the net income and gains of the S corporation are taxed only once, at the shareholder level.
13. What are the federal income tax reporting requirements for an S corporation? An S corporation must file an annual information return on Form 1120S. The S corporation reports all items of corporate income, deductions, gains, and losses on the Form 1120S. The form is due on or before the 15th day of the 3rd month following the close of the corporation’s tax year. An S corporation with a January 1 thru December 31 tax year will need to file its Form 1120S on or before March 15th of the succeeding calendar year.
In addition, the S corporation must also provide each shareholder with a Schedule K-1. The Schedule K-1 allocates to each individual shareholder his or her share of all items of corporation income, deduction, gain and loss, based upon the shareholder’s ownership interest in the corporation. The deadline for providing Schedule K-1s to the shareholders coincides with the filing deadline for the Form 1120S.
14. Can the S corporation status be terminated? S corporation status can be terminated either voluntarily or involuntarily. A corporation’s S corporation status is involuntarily terminated if any event occurs that would prohibit the corporation from making the election in the first place (a “disqualifying event”). Examples of a disqualifying event would include having more than 75 shareholders, a shareholder that is other than an individual, estate, or trust, or a shareholder who is a non-resident alien. Generally, the election is automatically terminated as of the date on which the disqualifying event occurs. However, if a corporation has both accumulated earnings and profits as well as passive investment income that exceeds 25 percent of the corporation’s gross receipts for three consecutive years, the corporation’S corporation election will be terminated beginning with the following tax year.
An S corporation election may be voluntarily revoked with the consent of shareholders holding more than 50 percent of the outstanding shares of stock (voting and nonvoting) on the day the revocation is made. As part of the voluntary revocation, the shareholders may designate a prospective effective date. If no date is specified, a revocation which is made on or before the 15th day of the 3rd month of a corporation’s tax year will be effective retroactive to the first day of the tax year. Any revocation made after the 15th day of the 3rd month of the corporation’s tax year will be effective on the first day of the following tax year.
15. Can a corporation, whose S corporation status was terminated or revoked, re-elect S corporation status? In general, a corporation may not re-elect S corporation status until the 5th year after the year in which the termination or revocation became effective. Exceptions may be made with the written consent of the Internal Revenue Service. If a corporation’s S election is inadvertently terminated or inadvertently invalid when made, and the corporation makes a timely correction, the IRS can issue a written consent to waive the termination or permit the election. In such a case, the corporation must correct any condition that barred the corporation from qualifying as an S corporation and must obtain any required shareholder consents. In addition, all shareholders must agree in writing to make any adjustments that may be required by the IRS.