S-Corps and Taxation Considerations – Wilson Rogers & Company

Electing S-Corp Status and Late Filing Relief

Filing Form 2553 is CRITICAL to being granted S-Corp status!

Every tax season we encounter some common issues and errors surrounding business owners who desire to be taxed as a S Corporation (S-Corp) by the IRS. What might those issues be? Well, usually one of the following:

Failing to make the S-Corp election entirely because they didn’t realize that Form 2553 needed to be filed with the IRS
Failing to make the election in a timely manner

In one of our previous posts we discuss the qualifications to become a S-Corp and some of the tax considerations. In this post, we are strictly going to discuss how to make the election and what to do if the deadline is missed.

When to Submit Form 2553

Form 2553 is used to tell the IRS that you want a corporation (or entity eligible to be taxed as a corporation, such as a single member LLC) to be taxed as a S-Corp. It is due:

No more than 2 months and 15 days after the beginning of the tax year the election is to take effect,
or at any time during the tax year preceding the tax year it is to take effect.

You can file the election at any time after thee above deadlines if your corporation meets the criteria for making a late S-Corp election (which we will discuss next).

It is important to note that the S-Corp election is made with the IRS, not the state. One is NOT changing their entity structure with the state. They are merely asking the IRS to tax the entity in a certain fashion. To help clarify what the election deadlines look like in practice, we’ve provided the following example:

Example 1 – New Corporation. New Corp, operates on a calendar year. It incorporated and began its first tax year on January 7th 2019. The 2-month period ends March 6th and 15 days after that is March 21st. To be a S-Corp beginning with its first tax year, it must file Form 2553 during the period that begins January 7th 2019 and ends March 21st 2019 (i.e. 2 months and 15 days after it incorporated). Because the corporation didn’t exist prior to January 7th, an election requesting an effective date prior to January 7th 2019 won’t be granted by the IRS.

Example 2 – New Corporation With Short Tax Year (less than 2 1/2 months). Short Corp, operates on a calendar year. It incorporated and began its first tax year on November 8th 2019. The 2-month period ends January 7th 2020 and 15 days after that is January 22nd 2020. To be an S corporation beginning with its short tax year, the corporation must file Form 2553 during the period that begins November 8th 2019 and ends January 22nd 2020. Because the corporation didn’t exist prior to November 8th, an election requesting an effective date prior to November 8th 2019 won’t be granted by the IRS.

Example 3 – Established Business. Old Corp, operates on a calendar year. It has been filing Form 1120 as a C corporation but wishes to make the S-Corp election for its next tax year (e.g. 2020) beginning January 1st. The 2-month period ends February 28th (the 29th in leap years) and 15 days after that is March 15th. To be a S-Corp in 2020, the corporation must file Form 2553 during the period that begins the first day (January 1st) of its last year as a C corporation (i.e. 2019) and ends March 15th of the year it wishes to be an S corporation (i.e. 2020). Because the corporation had a prior tax year, it can make the election at any time during 2019 but NO LATER than 2 months and 15 days beyond January 1st 2020 (i.e. the tax year the election is to be effective).

For the specific steps on when, where and how to submit your S-Corp election request, please refer to the Form 2553 Instructions per the IRS.

Requesting Relief for A Late S-Corp Status Election

So what happens if the deadline has passed to make the S-Corp election or you didn’t even know there was a deadline? Lucky for you, the IRS realizes that people makes mistakes and offers you some options to correct the oversight. They basically fall into the categories of:

Simply make the election effective for the NEXT year
Request relief stating that there was “reasonable cause”
Request relief using an IRS Revenue Procedure

Make the election effective next year. For those who miss the deadline, but don’t need it to be effective immediately, they can simply request that if be effective for the next year. For example, if you incorporate in late December 2019, but miss the March 15th 2020 deadline, you can always request that the election be effective for Tax Year 2021 by submitting Form 2553 prior to January 1st 2021.

Request relief on the grounds of reasonable cause. Reasonable cause refers to when a taxpayer didn’t file the forms on time due to a “valid reason” so to speak. In most cases, we’ve found the IRS to be fairly lenient when it comes to granting relief and allowing a corporation to elect S-Corp status in the year intended. Please note that reasonable causes may vary, and the IRS does not publish a list of what it considers to be one that is valid. However, there are numerous court cases that show that certain reasonable causes are “nearly always” allowed. Two of these typically include:

The company’s president, chief executive officer or similar responsible person neglected to file the election, or your corporation’s tax professional or accountant neglected to do so.
The corporation or its shareholders either did not know of the need to file an election or didn’t know they needed to file the election by a certain date.

If you are going to request relief on the grounds of reasonable cause, make sure that you address the following points within your statement:

What happened that caused the filing to be late and when did it happen?
How did these facts and circumstances result in the forms not being filed on time?
How did the company handle its financial and tax affairs during this time? Meaning, did they operate as if they were a S-Corp or did they delay individual income tax filings because they were intending to be a S-Corp?
What attempt did the company make to correct the situation when they learned they did not make the election correctly?

Request relief using an IRS Revenue Procedure. Rev. Proc. 2013-30 (PDF) facilitates the grant of relief to those who make a late S-Corp election. This procedure provides guidance for relief for late:

S corporation elections,
Electing Small Business Trust (ESBT) elections,
Qualified Subchapter S Trust (QSST) elections,
Qualified Subchapter S Subsidiary (QSub) elections, and
Corporate classification elections which the entity intended to take effect on the same date that the S corporation election would take effect.

Generally, the relief under the revenue procedure can be granted when the following requirements are met:

The entity intended to be classified as an S corporation, is an eligible entity, and failed to qualify as an S corporation solely because the election was not timely;
The entity has reasonable cause for its failure to make the election timely;
The entity and all shareholders reported their income consistent with an S corporation election in effect for the year the election should have been made and all subsequent years; and
Less than 3 years and 75 days have passed since the effective date of the election.

To assist in determining if an entity qualifies for late election relief, Rev. Proc. 2013-30 includes flow charts, as well as specific guidance for each of the five categories listed above.

If an entity does not qualify for relief under Rev. Proc. 2013-30, the entity may request relief by requesting a private letter ruling. The procedural requirements for requesting a letter ruling and the associated fees are described in Rev. Proc. 2019-1 (PDF). For more information on late election relief, check out this page on the IRS’ website.

Need help correcting a late S-Corp election? We’ve helped many companies that thought they filed their election or didn’t know they needed to file by a certain deadline obtain their desired S-Corp status. If you find yourself in this unfortunate predicament, you’re best advised to seek a professional who knows how to address the situation.

To that end, give us a call at 773-239-8850 or shoot us an email via the address contained in the footer of this page. The sooner you put us to work for you, the sooner you can have your election granted to you by the IRS!

S-Corps and Taxation Considerations

An S corporation (sometimes referred to as an S Corp) is a special type of corporation created through an IRS tax election (you must first incorporate the business and then make the IRS election via Form 2553). Many new business owners often contact us asking if this is a good form to conduct business under. While there are advantages to operating as an S Corp, there are some things that one should consider prior to making the election. Depending on your goals, one may find that it’s better to operate under another organizational structure.

Ownership Restrictions

Per IRS guidelines, S Corp owners (shareholders) must first meet the following criteria:

Limited to 100 or fewer persons/entities
Must be US citizens/residents (cannot be non-resident aliens)
Cannot be C Corporations (C Corp), other S Corps, limited liability companies (LLCs), partnerships or certain trusts
Any shareholder who works for the company must pay him or herself “reasonable compensation.” Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as “wages”

Benefits

Many small business owners elect S Corp status for two main reasons:

Avoid double taxation on distributions
Allow corporate losses to flow through to its owners (however there are 3 loss limitations discussed later)

Other typical advantages include:

Limited liability protection. Owners are not typically responsible for business debts and liabilities.
Easy transfer of ownership. Ownership is easily transferable through the sale of stock.
Unlimited life. When a corporation’s owner incurs a disabling illness or dies, the corporation does not cease to exist.
Potential use of personal assets for business use. Check out this post about S-Corp vehicle usage and this one for S-Corp home office usage.

Pass Through Taxation

What makes the S Corp different from C Corp is that profits and losses pass through to your personal tax return. Consequently, the business is not taxed itself, only the shareholders are taxed. The amount which is taxed is determined by the shareholders basis (i.e. their interest in the business). What is unique about S Corp basis is that it fluctuates depending on several things including the company’s operational performance.

Additionally, since the tax liability lies with the shareholder and not the corporation, individuals have to make sure that they receive enough money from the corporation in the form of distributions in order to satisfy their tax obligation. Non dividend distributions aren’t taxable to the extent the shareholder has adequate basis.

Importance of Basis

It is important that a shareholder know their stock AND debt basis at all times. As such, it is imperative that it be calculated every year. If the corporation allocates a loss or deduction to the shareholder, in order to claim it the shareholder needs to demonstrate that they have enough stock or debt basis. For example, if a person invests $10,000 in a company (i.e. stock basis) and the company then passes through a $18,000 loss to them in a single year, only $10,000 will be deductible in that year. The remaining $8,000 becomes “suspended” until the shareholder has adequate basis in the future.

Loss Limitations

As mentioned above, losses are limited to the extent that an owner has basis. However, there are in fact three limitations which could cause a loss to be nondeductible at any given time. Each limitation must be met in the following order before a shareholder is allowed to claim a flow through loss:

Stock and Debt Basis Limitations
At Risk Limitations
Passive Activity Limitations

Calculating Stock Basis

A good way to think of stock basis is in terms of a checking account. Basis essentially equals deposits and earnings less any withdrawals made. Furthermore, similar to a bank account (with no overdraft protection) basis cannot go negative – that is more cannot come out than goes in.

Initial basis typically starts with the money a shareholder paid for the S Corp shares, property contributed to the corporation, carryover basis if gifted stock, stepped-up basis if inherited stock or basis of C Corp stock at the time the C Corp converts to an S Corp.
Subsequent basis is made via adjustments which are typically recorded at the end of the corporations tax year. First they are increased by income items, then decreased by distributions and lastly decreased by deduction and loss items. The order is important because if basis is positive before distributions but would be negative if all deduction items were subtracted (however, again, basis cannot be negative) then the excess loss would be suspended rather than the excess distribution being taxable.

Other Important Considerations

S Corps must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.
The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
Under section 7436 of the Internal Revenue Code, the IRS has the authority to reclassify payments made to shareholders from non-wage distributions to wages (which are subject to employment taxes).
Suspended losses and deductions due to basis limitations retain their character in subsequent years. Any suspended loss or deduction items in excess of stock and/or debt basis are carried forward indefinitely until basis is increased in subsequent years or the shareholder disposes of their stock.
In determining current year allowable losses, current year loss and deduction items are combined with the suspended loss and deduction items carried over from the prior year, though the current year and suspended items should be separately stated on the Form 1040 Schedule E or other appropriate schedule on the return.
If the current year has different types of loss and deduction items, which exceed stock and/or debt basis, the allowable loss and deduction items must be allocated pro rata based on the size of the particular loss and deduction items.
If a shareholder sells their stock, suspended losses due to basis limitations are lost. Any gain on the sale of the stock does not increase the shareholder’s stock basis. A stock basis computation should be reviewed in the year stock is sold or disposed of.
A non-dividend distribution in excess of stock basis is taxed as a capital gain on the shareholder’s personal return. Stock held for longer than one year is a long-term capital gain (LTCG).

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