Forming an S-Corp can have several advantages both tax related and non-tax related but, before you start planning to form an S-Corp you need to know whether your eligible or not. Below we will discuss the qualifications that must be met to form an S-Corp, some important dates and timelines, and how the revocation/termination of an S-Corp can occur. If you are interested in learning more about the tax advantages of an S-Corp check out our blog about S-Corp Tax Savings.
WHAT ARE THE REQUIREMENTS?
Whether you just started your business or already have a business operating as a sole-proprietor, partnership, LLC, or C-Corp, this question is something you will need to answer before making the sub-chapter S election on form 2553.
To be eligible to make the S election the business:
- Must be a domestic corporation
- Cannot be an ineligible corporation (applies to certain banks, insurance companies, and foreign corporations)
- Can only have one class of stock
- Must have 100 or fewer shareholders
- Must timely file for the sub-chapter S election and 100% of the shareholders must agree to the election
ONE CLASS OF S-CORP STOCK
As stated above, the S-Corp may only have one class of stock. However, the stock can have differences in voting rights just not in liquidation or distribution rights.
An example why an S-Corp may have stock with different voting rights is the S-Corp is a family run business. The parents want to maintain control of the business but, they also want to give their children a piece of the business. So, they issue stock with voting rights to themselves to keep control of the business and issue the stock with no voting rights to their children.
ELIGIBLE SHAREHOLDERS OF AN S-CORP
To be eligible as an S-Corp it must have 100 or fewer shareholders but, not everyone can can be a shareholder in an S-Corp. So, who is eligible?
- Resident individuals
- Certain trusts and tax exempt organizations
- Charitable organizations
- Employee benefit trusts exempt from taxation
- One-person LLCs classified as a disregarded entity
It’s also important to remember that family members can be treated as a single shareholder (e.g. husband and wife).
Who cannot be a shareholder in an S-Corp?
- Nonresident aliens
- Business trusts
- Foreign trusts
- Most LLCs
- Most IRAs
S-Corps can be partners in a partnership or shareholders in a corporation.
FILING TO BECOME AN S-CORP
If you are already operating an LLC or Corporation and want to become an S-Corp for the current year you will need to make the election by the “15th day of the third month” (March 15th) or you will have had to file for the S election in the previous year. In some cases, you can still get the election after the deadline if you can provide “reasonable cause” for the delay.
For example, as of writing this we are in July of 2018. The deadline to elect to become an S-Corp for 2018 has passed because it was not made by March 15th of 2018. However, if you decide to still file for the S election after March 15th, starting on Jan. 1st of 2019 the business will be recognized as an S-Corp (again, unless you can show “reasonable cause”).
If you created an LLC or Corporation this year, you will want to make the election within two months and 15 days (generally 75 days) of formation…otherwise, without reasonable cause, you will be stuck as a C-Corp for the first year.
REVOCATION OF THE S ELECTION
The election to be an S-Corp will remain in force until the shareholders of the S-Corp decide to revoke the election or the election is terminated due to not meeting the eligibility requirements.
In order for the S election to be revoked, the shareholder(s) that hold more than 50% of the voting rights in the S-Corp must vote to revoke the S election.
- The revocation must be filed by the 15th day of the third month (March 15th) in order for it to be effective for the current year. If this is not done, the revocation will be effective on the 1st day of the following year (similar to making the S election).
- A specific day can be set for the revocation as well. However, this will split the year and cause the need for short year returns to be filed.
TERMINATION OF THE S ELECTION
The S election can be terminated if a new shareholder who obtains more than 50% of the stock with voting rights, does not consent to the S election.
There is also a passive investment income limitation that, if not met by the S-Corp, will effectively terminate the S election. If the S-Corp’s earnings and profits (you would generally only have this if the S-Corp were previously a C-Corp) and passive investment income are greater than 25% of the gross receipts of the S-Corp for three consecutive years, the S election will be terminated in the fourth year.
An S election can also be terminated if the S-Corp no longer qualifies as a small business corporation, meaning it does not meet any of the eligibility requirements stated above.
- The effective termination date of the S election is the date the disqualification occurs.
HOW TO REGAIN THE S ELECTION AFTER TERMINATION
The waiting period for the S election to be regained after termination is five years, which does not start until the year following the year the termination took place. This waiting period can be waived if:
- A greater than 50% ownership change occurs after the first year of termination.
- The event(s) that caused the S election to be terminated were beyond the control of the S-Corp or it’s majority shareholders. In this specific case, you would need to prove the event(s) were beyond the control of the S-Corp or it’s majority shareholders and present your case to the IRS.
Making sure these requirements to become an S-Corp are met and maintained are vital to avoiding a run-in with the IRS. Often times a person attempts to form the S-Corp on their own using sites that”streamline” the process. Though these sites can be helpful and in some cases do a good job in taking you through the steps, it is ultimately up to you to fill the paperwork out and make sure it is done correctly. If something is not filed or filled out properly, you may end up running your business as an entirely different entity for at least the next year and come tax time that could cause serious issues, especially if you thought you were an S-Corp and ran the business as such.