There are many good reasons to convert your business to an S Corporation. The opportunity to save on taxes is likely the chief reason.
Forming an S Corporation may appear simple but there are some hidden rules that become potholes if they are not avoided.
It is crucial for a business owner to identify these rules so that they work to his advantage when operating as an S corporation.
1 – Operating as an S Corporation
Here are some basic requirements to operate as an S corporation:
- The S corporation should be a domestic corporation.
- The S corporation should have fewer than 100 shareholders.
- The S corporation shareholders can only be people, estates, and certain types of trusts.
- The S corporation’s stockholders should all be U.S. residents.
- The S corporation should have only one class of stock.
The worst-case scenario is that if the S corporation reverts to a C corporation, it stays as a C corporation for three years. Business owners should not let that happen.
Here are some of the hidden rules to watch out for.
2 – Issues of the Spouse
When living in a community property state, the business owner’s spouse by reason of community property may be an owner of the corporation. This is true whether or not the spouse has stock in his or her own name.
If the spouse is an owner, he or she has to meet all the same qualification requirements as the business owner. Two issues are raised because of this.
- If the spouse does not consent to the S corporation election on Form 2553, the S corporation is not valid.
- If the spouse is a non-resident alien, the S corporation is not valid.
3 – The LLC to S Corporation Conversion
For tax purposes, converting an LLC to an S corporation is as easy as filing a single form with IRS.
- The LLC Owners file IRS Form 2553 to elect to treat the LLC as an S Corporation.
4 – Loans that can Kill the S Corporation Status
A bad or wrong type of loan made by the business owner to the S corporation enables the IRS to treat that loan as a second class of stock that disqualifies an S corporation.
Small loans. The second-class-of-stock trap is avoided if the loan is less than $10,000 and the corporation promises to repay the loan to the business owner in a reasonable amount of time.
Large loans. The second-class-of-stock trap is avoided if a large loan (in excess of $10,000) meets the following requirements:
- The loan is in writing.
- The loan repayment has a firm deadline.
- The loan cannot be converted into stock.
- The repayment instrument fixes the interest rate so that the rate is outside the business owner’s control.
5 – A Separate Class of Non-Voting Stock
The one-class-of-stock requirement is one of the biggest complaints about S corporations. There can actually be separate classes of stock as long as the only difference between them is the voting rights of each class. Both voting stock and non-voting stock can be created as long as all the other aspects of the stock are the same.
If a business owner wants to give someone distributions, allow them to share in the profits, but not let them have any control over business decisions, they can be given non-voting stock. Non-voting stock can be very helpful if a business owner wants to give money to someone in a lower tax bracket such as retired parents.
6 – The Importance of the Time of Filing
A business, in general, needs to meet the requirements for S corporation status on the day it files the S corporation election.
For example. If a business wants to be an S corporation on January 1, 2023, it needs to file its election in 2022 and elect January 1, 2023 as the effective date for the election. The IRS will check if the business meets the requirements as of the day in 2022 when the election was filed.
What if the business wants to be an S corporation but doesn’t file the form before the end of the year? The tax code gives the business the first two months and 15 days of the next year to file the election and have it become effective retroactively on the first day of the year. This means that a calendar-year business must file by March 15 to make the election effective on January 1.
However, in order to file in this expanded period, the business must meet the requirements for S corporation status for the entire year, even the period before the election was filed.
Everyone who has held stock in the corporation for that year must also give their consent.
For instance, a business wants to convert to an S corporation in 2023. It can file for election as late as March 15, 2023, but the business must first meet all the S corporation requirements as of January 1, 2023.
If the same business above is in a community property state and the business owner gets divorced in February 2023, the ex-spouse’s consent to the S corporation election is needed because he or she was a shareholder in January, or during the time of the marriage.
7 – Extra Taxes Some C Corporations Need to Know
Businesses that operated as a C corporation may face some special issues when it is converted into an S corporation. Since these special issues can be fairly complicated, business owners should keep an eye out for them.
Built-in gains tax. If a C corporation’s assets are worth more than their basis, business owners could face some high taxes when these assets are sold.
Loss of tax attributes. If a C corporation had loss carryover or minimum tax credits, the tax code generally does not allow them while the business is an S corporation.
LIFO recapture. Business owners may face a recapture tax if their C corporation used the LIFO (last in, first out) method of accounting for their inventories.
Passive investment income. Business owners may face a higher tax if their previous C corporation had accumulated earnings and profits and then more than 25 percent of their S corporation’s income comes from passive investment income. Passive investment income is generally income from royalties, rents, dividends, interest, and annuities.
Converting to an S Corporation is very easy if you follow the rules above and get the timing right.