Your business must meet specific requirements when it operates as an S corporation. If you violate any of them, your S-corporation reverts into a C corporation for three years which will result in double taxation and potentially be a costly error:
- The S corporation must be a domestic corporation.
- The S corporation must have less than 100 shareholders
- The shareholders can only be people, estates, and certain types of trusts
- All stockholders must be U.S. residents
- The S corporation can have only one class of stock
If you live in a community property state, your spouse may be an owner of the corporation whether the stock is in only one person’s name because of community property law. If your spouse is an owner, your spouse must meet the all the S-Corporation qualification requirements. Your spouse must consent to the S corporation election on Form 2553 and your spouse must be a US resident.
You can create an LLC and then convert that LLC into an S corporation by following “Check and Elect” procedures:
- File IRS Form 8832 to check the box that converts your LLC to a C corporation
- Then file Form 2553 to convert your C corporation into an S corporation
Taxpayers can make these elections within the first two months and fifteens days of the next year to have it effective on the first day of the year. In general, your business needs to meet the requirements for S-corporation status on the day it files the S corporation election. For a calendar-year business, this means it must file by March 15 to have the election effective on January 1. The business would be required to meet the requirements for S corporation status for the entire year, even the period before you filed the election. Business owners must also obtain the consent of everyone who held stock in your corporation for that year to complete the election.
Specific types of loans can have negative implications to S-Corporations status with the IRS. If business owners make the wrong type of loan to their S-corporation, the IRS will treat that loan as a second class of stock and disqualify the S corporation. If the loan is less than $10,000 and the corporation has a written promised to repay you in a reasonable amount of time the loan will not be treated as a second class of stock and the S-Corporation will maintain its status.
If you have a larger loan, your loan is not considered a second class of S if it meets the following requirements
- The loan is in writing.
- There is a firm deadline for repayment of the loan
- You cannot convert the loan into stock
- The repayment instrument fixes the interest rate so that the rate is outside your control
S-Corporations can have separate classes of stock, as long as the only difference between them is the voting rights of each class For example, you can create both voting stock and nonvoting stock, as long as all other aspects of the stock are the same. This is useful if you want to give someone distributions but not let that person have any control over business decisions. Nonvoting stock can be very useful tax planning tool if you want to give money to someone in a lower tax bracket, such as your retired parents. We cover this strategy in more detail in later articles.
If you previously operated your business as a C corporation, you face special issues when you convert to an S corporation. These can be complicated, and will be covered in later articles.
Below are some issues to keep in mind:
- Built-in gains tax
- Loss of tax attributes.
- LIFO recapture.
- Passive investment income
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