16.1 S corporation eligibility and election
4 min read•july 30, 2024
S corporations offer unique tax advantages for small businesses. These entities allow income and losses to pass through to shareholders, avoiding double taxation. However, strict eligibility requirements and election procedures must be followed to maintain status.
Understanding S corporation rules is crucial for tax planning. From shareholder limitations to stock restrictions, each requirement plays a role in determining eligibility. The election process, including filing deadlines and potential revocation scenarios, further shapes the S corporation landscape.
S Corporation Eligibility Requirements
Domestic Corporation and Shareholder Limitations
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- S corporations must be domestic corporations formed and operated under U.S. federal or state law
- Eligible entities are limited to 100 or fewer shareholders
- Family members can count as a single shareholder under specific rules
- Shareholders must be individuals, certain trusts, or estates
- Partnerships, corporations, and non-resident aliens are generally not
Stock and Entity Restrictions
- S corporations can only have
- Differences in voting rights are permitted
- Certain types of corporations are ineligible including
- Financial institutions using the reserve method of accounting for bad debts
- Insurance companies
- Domestic international sales corporations (DISCs)
Tax Year Requirements
- S corporations must use a permitted tax year
- Generally the calendar year unless a business purpose for a different tax year is established
- Fiscal year may be allowed if it aligns with the corporation's natural business cycle (retail companies using January 31 fiscal year end)
Electing S Corporation Status
Filing Requirements and Deadlines
- Election for S corporation status made by filing , "Election by a Small Business Corporation," with the Internal Revenue Service
- All shareholders must consent to the S corporation election
- Signing Form 2553 or a separate consent statement
- Filing deadlines
- No later than two months and 15 days after the beginning of the tax year the election takes effect
- Any time during the preceding tax year
- Late elections may be accepted if the corporation shows reasonable cause for the delay
- Oversight by tax professional
- Misunderstanding of filing requirements
Effective Dates and Special Cases
- Effective date of S corporation election typically beginning of corporation's next tax year
- Specific date may be requested and approved
- Newly formed corporations can have S election effective from date of incorporation
- Must file within two months and 15 days of formation
- Mid-year elections may be allowed in certain circumstances
- Corporation converting from C to S status
- New corporation electing S status in its first year
Revoking S Corporation Election
Voluntary and Involuntary Termination
- S corporation election can be revoked voluntarily
- Requires consent of shareholders owning more than 50% of stock
- Involuntary termination occurs if corporation ceases to meet eligibility requirements
- Exceeding 100 shareholders
- Having an ineligible shareholder (corporation or partnership)
- Once S corporation election terminated, corporation generally cannot re-elect S status for five years without IRS consent
Tax Implications of Termination
- Upon termination, corporation becomes a C corporation subject to corporate-level taxation
- Tax year of termination split into two short tax years
- One for S corporation period
- One for C corporation period
- may apply to appreciated assets
- Conversion back to C corporation status within five years of electing S status
- Accumulated Adjustments Account (AAA) becomes frozen upon termination
- Distributions from AAA may be made tax-free to shareholders for a limited time
S vs C Corporation Taxation
Pass-Through vs Separate Entity Taxation
- S corporations are pass-through entities
- Income, deductions, and credits flow through to shareholders' individual tax returns
- C corporations are separate taxable entities
- Subject to corporate tax rates (21% flat rate as of 2021)
- S corporations generally do not pay federal income tax at corporate level
- C corporation shareholders potentially subject to double taxation
- Once at corporate level
- Again when dividends distributed
Income Reporting and Loss Treatment
- S corporation shareholders report share of corporate income on personal tax returns
- Regardless of whether distributions are made
- C corporation income taxed at corporate level
- Shareholders taxed only on distributed dividends
- S corporation shareholders can deduct share of corporate losses up to their basis
- C corporation losses remain at corporate level
- Cannot be deducted by shareholders
Special Tax Considerations
- S corporations not subject to accumulated earnings tax or personal holding company tax
- May apply to C corporations
- Fringe benefits treatment differs for shareholder-employees
- S corporations face more restrictions on tax-free benefits
- Health insurance premiums for 2%+ shareholders
- Certain retirement plans
Key Terms to Review (19)
100 shareholder limit: The 100 shareholder limit is a critical feature in the context of S corporations, which restricts the number of shareholders an S corporation can have to no more than 100. This limitation helps maintain the S corporation's status as a pass-through entity for tax purposes, allowing it to avoid corporate income tax while ensuring that income is taxed at the shareholder level. It also fosters a closer-knit ownership structure, facilitating easier management and operations.
Built-in gains tax: The built-in gains tax is a federal tax imposed on S corporations when they sell or exchange assets that have appreciated in value while they were a C corporation. This tax is designed to prevent corporations from converting to S corporation status to avoid taxation on gains accumulated prior to the election. When an S corporation sells such appreciated assets within a specified recognition period, it must pay this tax, effectively ensuring that the previous gains are taxed appropriately.
Corporate Income Tax: Corporate income tax is a tax imposed on the income generated by corporations, calculated as a percentage of their taxable income. This tax affects how businesses operate and make decisions, as it influences profitability and capital investment strategies. Corporations must comply with specific requirements to determine their tax liabilities, which often involve deductions, credits, and other tax provisions that can impact their overall financial performance.
Distribution taxation: Distribution taxation refers to the tax implications associated with distributions made by an S corporation to its shareholders. These distributions are generally not taxed at the corporate level, allowing for a pass-through taxation structure, which means income is only taxed at the individual level when distributed to shareholders. This mechanism ensures that S corporations avoid double taxation, a hallmark of traditional C corporations, while also imposing specific tax obligations on shareholders depending on their basis in the corporation.
Double taxation avoidance: Double taxation avoidance refers to the measures implemented to prevent the same income from being taxed in multiple jurisdictions, ensuring that individuals or entities are not taxed twice on the same income. This concept is crucial for S corporations as it allows income to pass through to shareholders without facing corporate tax, which aligns with the tax benefits intended for this type of business structure.
Eligible shareholders: Eligible shareholders refer to individuals or entities that meet specific requirements to own shares in an S corporation. These shareholders must be U.S. citizens or resident aliens, and they cannot be corporations, partnerships, or certain trusts. Understanding who qualifies as an eligible shareholder is crucial for ensuring that the S corporation maintains its special tax status and benefits.
Form 1120S: Form 1120S is the U.S. tax return specifically used by S corporations to report income, deductions, gains, losses, and other tax-related information to the Internal Revenue Service (IRS). This form is crucial as it outlines how the corporation’s income and losses are allocated to shareholders, helping them report their share of the S corporation's income on their personal tax returns. The form also plays a key role in understanding the taxation of built-in gains and passive income limitations for S corporations.
Form 2553: Form 2553 is the IRS form used by eligible small businesses to elect S corporation status for federal tax purposes. By filing this form, corporations can enjoy pass-through taxation, allowing income, losses, deductions, and credits to be passed directly to shareholders, avoiding double taxation at the corporate level. This election is crucial for small businesses seeking tax benefits while maintaining a corporate structure.
Inadvertent termination: Inadvertent termination refers to the unintentional loss of S corporation status due to a failure to meet the eligibility requirements or election processes mandated by the IRS. This can occur from actions such as exceeding the limit on the number of shareholders or having ineligible shareholders without realizing it, leading to the automatic conversion of the S corporation into a C corporation. Such changes can have significant tax implications for both the corporation and its shareholders.
Limited Liability Company (LLC): A Limited Liability Company (LLC) is a flexible business structure that combines elements of both corporations and partnerships, offering personal liability protection to its owners, known as members. This structure allows for pass-through taxation, meaning that profits and losses can be reported on the members' personal tax returns, avoiding the double taxation typically associated with corporations. An LLC is particularly appealing for small businesses and entrepreneurs because it provides limited liability protection while allowing for a simpler management structure.
Limited liability protection: Limited liability protection is a legal concept that protects the personal assets of shareholders in a corporation or members in a limited liability company (LLC) from being used to satisfy the debts and obligations of the business. This means that if the business incurs debt or faces lawsuits, the personal assets of the owners, such as their homes and savings, are generally shielded from claims made against the business. This feature encourages entrepreneurship by reducing the financial risk associated with starting and operating a business.
One class of stock: One class of stock refers to a single type of stock issued by a corporation that has uniform rights and privileges, particularly in terms of voting and dividend distribution. This structure is significant because it ensures that all shareholders have equal say in corporate governance and profit-sharing, aligning with the requirements for S corporation eligibility. By maintaining only one class of stock, companies can avoid complexities related to different rights attached to multiple classes, which is crucial for S corporation status.
Ordinary business income: Ordinary business income refers to the income earned by a business from its regular operations, excluding capital gains, losses, and non-operating income. It is critical for tax purposes, especially in determining how income is allocated to shareholders of S corporations, as it directly impacts their tax liabilities. This type of income is also essential for understanding the eligibility and election process for S corporations since only certain types of income qualify for S corporation status.
Pass-through taxation: Pass-through taxation is a tax structure where the income generated by a business entity is not taxed at the corporate level but instead 'passes through' to the owners or shareholders, who report it on their individual tax returns. This method helps avoid double taxation, making it an appealing option for various business entities, including partnerships and S corporations.
Resident alien: A resident alien is a non-citizen who meets specific criteria to be treated as a U.S. resident for tax purposes, primarily based on their physical presence in the country. This status allows them to be taxed similarly to U.S. citizens on their worldwide income, which significantly impacts their eligibility for certain tax benefits and responsibilities.
Revocation of s status: Revocation of S status refers to the process by which an S corporation loses its election to be taxed as an S corporation under the Internal Revenue Code. This can happen either voluntarily, by filing a statement with the IRS, or involuntarily, if the corporation fails to meet the eligibility requirements. Once revoked, the corporation will be taxed as a C corporation unless it reinstates its S status after a waiting period.
S Corporation: An S Corporation is a special type of corporation that meets specific Internal Revenue Code requirements, allowing it to be taxed as a pass-through entity, which means that income, losses, deductions, and credits flow through to the shareholders' personal tax returns. This structure provides the limited liability of a corporation while avoiding double taxation on corporate income, making it an attractive option for small businesses. The election to be treated as an S Corporation can influence its capital structure and tax implications, including restrictions on built-in gains and passive income.
Self-employment tax: Self-employment tax is a tax imposed on individuals who work for themselves, which consists of Social Security and Medicare taxes primarily for individuals who earn income from self-employment. This tax ensures that self-employed individuals contribute to these federal programs, similar to how employees have payroll taxes withheld by their employers. It's important for those operating as sole proprietors, single-member LLCs, or partners in a partnership to accurately calculate and report this tax to avoid penalties and ensure compliance with federal regulations.
Trusts as Shareholders: Trusts as shareholders refer to the legal arrangement where a trust entity holds shares in a corporation, allowing the trust to act as a shareholder for the purposes of ownership and distribution of profits. This setup can affect the way income is taxed, as well as the eligibility and management of S corporations, since specific rules govern who can be shareholders and how trusts may participate in ownership.