This article provides some brief insight surrounding the initial steps in making an S election. The entirety of issues that may arise can often be mitigated, if not entirely avoided, with proper tax planning. The scope of this article should familiarize a taxpayer with the different tax statuses of businesses and the legal eligibility requirements of S corporations.
Many business owners may find the tax treatment of an S corporation to be preferential to that of a C corporation or partnership. Subchapter S, while thorough, does provide a less complex set of rules. However, to avail oneself to Subchapter S, the first inquiry surrounds eligibility.
Selecting the Tax Status
For federal tax purposes, the Internal Revenue Code and the regulations thereunder, provide optionality for the tax treatment of a trade or business. In tax parlance, these are the “check-the-box” regulations. Under these regulations, a taxpayer may decide the tax status of an entity if it is an “eligible entity”.
Generally, for tax purposes, the regulations provide that an eligible entity may be treated as a disregarded entity, a partnership, or a corporation (association). Treas. Reg. § 301.7701-2(a). Additionally, an entity meeting all statutory requirements may file an S election. § 1362(a). Filing such election then provides for tax treatment as an S corporation. § 1363.
In some cases, the regulations mandate that an entity be treated as a corporation for tax purposes. Treas. Reg. § 301.7701-2. Often times, the entities on that list are called “per se corporations”. Naturally though, as an S corporation must be a domestic corporation, much of the per se corporation regulation is inapplicable. Furthermore, the state level entity choice need not be a corporation. Instead, a Limited Liability Company (LLC) will suffice.
Therefore, the choice of entity at the state level will not always be determinative of the corresponding tax status. Typically, forming an LLC provides the most flexibility for tax purposes while still providing the liability shield often sought by owners. Under state law, the liability protection provided between the various entity structures is one important non-tax reason for choice of entity. State tax codes can also become traps for the unwary when a state tax code accords different tax treatment than its federal counterpart.
In any event, after setting up an LLC, a taxpayer may choose its federal tax status under the regulations. If a taxpayer does not make a selection, then the regulations provide a default classification for the entity. Thus, checking the proverbial box is only necessary when seeking a different tax status from the default classification.
By default, an eligible entity with two or more members shall be treated as a partnership. Treas. Reg. § 301.7701-3(b)(1)(i). Alternatively, the taxpayer may select (check-the-box) to be treated as either a corporation or a partnership. Treas. Reg. § 301.7701-3(a). On the other hand, the regulations classify a single member entity as a disregarded entity. Treas. Reg. § 301.7701-3(b)(1)(ii). However, at the taxpayer’s election, the single member entity may be treated as a corporation. Treas. Reg. § 301.7701-3(a). As one additional option, Congress created the S election. From a technical standpoint, the S election is separate from the check-the-box regulations. See Treas. Reg. § 1.1362-6(a).
Election Eligibility
The first inquiry in evaluating the S corporation election is checking the eligibility rules. To make a valid § 1362 election (S election), a corporation (or LLC) must meet and adhere to certain requirements. Under federal tax law, the business must meet the definition of a small business corporation. § 1361(a)(1). However, the name is a misnomer—the entity need not be small with regard to income, operations, or geographical range. As discussed below, the entity must be a domestic corporation, but may conduct business abroad.
To meet the proscribed standard, the S corporation must be a domestic corporation and cannot have more than 100 shareholders. § 1361(b)(1)(A). Generally, those shareholders must be domestic individuals i.e., citizens and resident aliens. § 1361(b)(1)(B), (C). The S corporation must have only one class of stock—as opposed to C corporations issuing preferred and common shares. § 1361(b)(1)(D). The corporation must also not be an ineligible corporation within the meaning of § 1361(b)(2). An ineligible corporation is fairly uncommon as the definition includes certain insurance companies, DISCs, and certain financial institutions. § 1361(b)(2)(A)-(C).
These qualifying attributes—domestic corporate status, shareholder limitations, share limitation—must be maintained by the shareholders and the corporation at all times. Otherwise, the S election may be revoked by operation of law. In other words, a corporation may incidentally forfeit its S election. Notably, losing the S-corp status often prevents reacquiring that status for multiple years. § 1362(g).
While the foregoing paragraphs may sound simple enough, the rules, regulations, and case law do expound quite a bit on each requirement. An important tool to mitigate the odds of an adverse event, or potentially prevent them altogether, is to put in place a circumspect shareholder agreement.
Once an enterprise is ready to make the election, the corporation must timely file Form 2553. If the form contains all necessary information, signed by the authorized signatory, and all shareholders consent to the election, then the S election becomes effective. Again, this seems simple enough, but latent issues may exist, or future events may produce troubling unforeseen outcomes.
To name a few, the issuance of debt might be considered preferred stock, a shareholder may marry a nonresident individual that busts the S election, a resident alien might become a nonresident alien for one year and bust the S election, a former shareholder may need to provide consent even without any current equity ownership, and many other issues.
Conclusion
For federal tax purposes, the choice of entity carries a great deal of significance. Initially, taxpayers will want to familiarize themselves with the general rules for each type of entity. Subsequently, the taxpayer should determine his or her own tax profile to appropriately examine which choice might be best. Once that determination is made, a taxpayer should make sure nothing bars selecting the most preferential entity.
As will be covered in a future publication of this series on S corporations, the operative tax rules are critically important in making a final determination. The intricacies of Subchapter S warrant thorough review. Particularly, the mechanical rules under Subchapter S for income and loss will help taxpayers understand whether or not an S-corp is most beneficial to their particular tax profile. In the forthcoming article, I’ll cover the operative tax rules that apply to the S corporation and its shareholders.
