An S-corporation is a state law entity designation, similar to a Florida corporation or a Florida limited liability company. However, an S-corporation is merely a federal income tax classification made on a specific Internal Revenue Service form (Form 2553). Thus, one can form a Florida limited liability company (“LLC”) and elect to be an S-corporation for federal income tax purposes with the Internal Revenue Service (“IRS”).
Who is eligible to make the election?
Generally, the entity wishing to make the election needs to be a domestic corporation or an LLC. However, certain types of businesses are ineligible to make the election, such as insurance companies or financial institutions. In addition, the entity must have eligible shareholders, meaning the owners of the entity must meet specific requirements of the Tax Code.
Who can be an eligible shareholder?
- So long as the individual is not a non-resident alien, individuals are eligible S-corporation shareholders. Individuals may co-own an S-corporation with other individuals, such as husband and wife, as joint tenants by the entirety.
- If an individual shareholder declares bankruptcy, the bankruptcy estate is a permissible S-corporation shareholder. If an individual shareholder passes away, their estate is an eligible S-corporation shareholder, as well.
- Testamentary Trusts. These trusts become effective upon the death of a shareholder and hence become eligible to be an S-corporation shareholder.
- Voting Trusts. Shareholders may create these trusts to temporarily transfer their shares to the trustee to combine their voting power. Voting trusts are eligible to be S-corporation shareholders.
- Qualified Subchapter S Trust (“QSST”). A QSST is an eligible S-Corporation shareholder if it meets specific rigid requirements.
- Small Business Trust (“ESBT”). An ESBT is a trust for beneficiaries that are all eligible s-corporation shareholders that acquired their trust interest by lifetime gifts or upon the death of an owner. These are more flexible trusts than the QSST described above.
Coming back to the opening question of an LLC or an S-corporation, so long as the individuals forming the LLC are eligible shareholders described above, the LLC can make the election treated as an S-corporation.
When to make the election?
Upon forming a new entity with owners contemplating this type of election, the entity has only two months and fifteen days from the date of formation or incorporation to file the election with the IRS. The IRS does offer late election relief. Without getting too intertwined in the weeds, in 2013, the IRS issued what is known as a “Revenue Procedure,” which describes how a taxpayer may obtain late election relief.
An entity must meet five (5) strict requirements listed in order to obtain late election relief. The IRS states that if the entity cannot meet these five requirements, it may submit a private letter ruling. Briefly, a private letter ruling allows taxpayers to submit requests to the IRS (for a hefty fee) and enables the IRS to rule on the facts presented. This allows the taxpayer applying for the private letter ruling — and only that specific taxpayer — to rely on the IRS’s ruling to those facts.
Before forming any entity, it is important to discuss which type of entity you will form for state law purposes with the appropriate advisors. If an S-election or any tax election is selected, make sure to make a timely election to avoid undue stress and additional fees.
Benefits of making the election
Generally speaking, the advantages of making the election will outweigh the disadvantages. Making the election can be especially beneficial when the time comes to transfer ownership or discontinue the business. Consider the following:
- Protection of Assets. Making the S-corporation election will not defeat any liability protection a corporation or LLC affords its owners. Thus, if an entity makes the election as an LLC, the LLC members (now considered shareholders with a valid election) will still have their personal assets protected. A shareholder (member of the LLC) does not have personal liability for the business debts and liabilities of the entity unless there is a personal guarantee.
- Pass-Through Taxation. A C-corporation carries the stigma of double taxation; tax at the corporation level and tax again upon the distribution to shareholders. With an election in effect, the entity is taxed as a pass-through entity, meaning there is no entity-level tax and all items of income and deduction flow through to the shareholders. This means that the business losses can offset the other income on the shareholder’s personal tax return to reduce income tax paid.
- Characterization of Income. A shareholder of an S-corporation can be an employee of the business and draw a salary. They can also receive dividends from the corporation and other distributions that are tax-free up to the shareholder’s investment in the corporation. If done correctly, a reasonable characterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability while still generating business-expense and wages-paid deductions for the corporation.
- Transfer of Ownership. Interest in an S-corporation can be freely transferred without triggering adverse tax consequences. The corporation will not need to adjust the property basis or comply with complicated accounting rules, similar to a partnership. I caution you to be mindful that the individual or entity receiving the transferred interest in the S-corporation is an eligible S-corporation shareholder. If not, the transfer may inadvertently blow the election.
- Method of Accounting. Typically, a C-corporation is required to use the accrual method of accounting unless the corporation is small, meaning its gross receipts is five million dollars ($5,000,000) or less. However, an S-corporation is typically not required to use the accrual method of accounting and may use the cash method, so long as the S-corporation does not have any inventory.
Disadvantages to making the election
You may be asking yourself at this point, is an S-corporation too good to be true? Are there are any disadvantages to making the election? Why would an entity not make the election? There are a few disadvantages to the election, as discussed below:
- First, there are formation fees associated with the entity making the election. Articles of Organization for an LLC or Articles of Incorporation for a corporation will need to be filed; both carry fees that will need to be paid to the state where formed. In addition, many states, including Florida, impose an annual report fee each year to keep the entity active. These fees are usually not expensive and can be deducted as a cost of doing business. It is important to note here that the fees associated with the formation will hold true regardless of making the election or not.
- Tax Obligations. As mentioned above, not making the election in a timely fashion will have adverse consequences on the entity. In addition, there are stock ownership, election, and consent requirements that, if not met, may cause the entity to blow their election inadvertently.
- Calendar Year. An S-corporation must adopt a calendar year unless it can establish a business purpose for having a fiscal year.
- Stock Restrictions. An S-corporation can only have one (1) class of stock with voting and non-voting shares. However, there cannot be different classes of investors entitled to different dividends or distribution rights, similar to a C-corporation stock structure. In addition, there can only be a total of one hundred (100) shareholders of an S-corporation (there are special attribution rules that will apply to determine the number of shareholders, for example, a husband and wife will be considered as one (1) shareholder for this purpose). As mentioned above, non-resident aliens cannot be shareholders of an S-corporation.
- Flexibility with Income and Losses. Due to the one class of stock restriction, S-corporations cannot easily allocate losses or income to specific shareholders. The allocation of an S-corporation is governed by the stock ownership instead of an entity treated as a partnership for federal tax purposes.
Having knowledgeable advisors to guide you through this process is key. In addition to that factors listed above one should consider if the LLC will own real property, have passive income, or the cost of filing the appropriate tax returns. Those needing assistance may reach me at firstname.lastname@example.org or by phone at 239-344-1147. Virtual appointments are available.