Forming an S Corporation and Filing IRS Form 2553
The Rules and Procedure for Electing S Corp Status
When you form a corporation, the Internal Revenue Service assumes that it's a C corporation unless you take an additional step. All corporations are treated as C corps by default. If you don't take the extra step of electing S corporation status, your business will pay a corporate income tax on its net taxable income for the year.
This might be a good thing in light of the Tax Cuts and Jobs Act that goes into effect in 2018.
Or it might not be so good, depending on your personal circumstances and your goals.
The Pros and Cons of Choosing S Corp Status
A corporation's taxable income is imputed to each of its shareholders when an S corporation is formed. That imputed income is then included on each shareholder's personal tax return.
This could be quite beneficial through the 2017 tax year. The corporate tax rate at that time was 35 percent. A single individual could earn up to $416,700 annually without hitting this tax bracket, so the tax burden on the corporation's income would often be less by imputing the income to its shareholders.
The TCJA slashes the corporate tax rate to 21 percent. A single individual would hit a similar personal tax bracket—22 percent—at an income of just $38,701, so a C corp could theoretically save 1 percent by retaining its income and paying the axes on it.
But, of course, nothing's quite that simple when it comes to taxes.
There's an additional benefit in choosing S corporation status. The S corp's net income is taxed only once at the shareholder level. By contrast, the net income of a C corporation could potentially be taxed twice, once at the corporate level and again at the shareholder level when any dividends are paid out.
Shareholders would still have to report those dividends as income on their personal returns.
Forming an S Corporation
If you've decided that forming an S corporation works in your favor, you must prepare and file Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service. This notifies the IRS that you want to elect S corp status. The IRS will then send a letter back to your corporation confirming its election for this tax treatment.
First, however, you must incorporate your business. Draw up articles of incorporation, by-laws, and the various required legal documents to form and operate your business. These can vary by state. You should incorporate the business in the state where the company will conduct the bulk of its business,
Verify that your corporation meets the eligibility criteria for being an S corporation, then file Form 2553 with the IRS. The form requires the signature of each shareholder.
When to Submit Form 2553
Form 2553 must be filed before the 16th day of the third month of the corporation's tax year, or before the 15th day of the second month of a tax year if the tax year is 2½ months or less. You can also file the form at any time during the tax year before the year in which you want the election to take effect.
You can file at any time after these deadlines if your corporation follows special rules for making a late S corporation election.
Yes, it sounds confusing. Here are some examples.
- ABC Corporation incorporated on July 1. ABC therefore has until October 16 to file Form 2553 for the S corporation election to be valid for the company's first year of operation.
- DEF Corporation incorporated on November 1 so its first tax year would be less than 2½ months long—November 1 through December 31. DEF therefore has until January 15 of the following year to file Form 2553 for the S corporation election to be valid for the company's first year of operation.
- GHI Corporation has been incorporated for several years and is currently taxed as a C-corporation. GHI can file Form 2553 by December 31 if the company wants to convert to an S corporation in the following year.
Procedures for Late Elections for S Corporation Status
A corporation can file Form 2553 after the due date and still receive IRS approval to make the election retroactive to the beginning of the corporation's tax year.
Normally, if a corporation files Form 2553 after the 15th day of the third month of its tax year but before the 15th day of the third month of the following tax year, the IRS considers the S corporation election to be valid for the following tax year, but not valid for the preceding tax year. But first the corporation must make sure that it is eligible to make a late election.
The corporation must meet S corporation eligibility criteria, and it must have intended to be classified as an S corporation as of the intended effective date of the S corp election. The corporation can only have failed to qualify as an S corporation because it did not file Form 2553 in a timely manner, not for any other reason. It must have reasonable cause for missing the deadline, but the IRS is pretty generous in this regard. Inadvertently failing to file Form 2553 is considered reasonable cause.
The corporation must also provide statements that each of its shareholders have reported their incomes in a manner inconsistent with the corporation's intention to file as an S corporation.
If your corporation meets these requirements, you should write the following at the top of Form 2553:
"FILED PURSUANT TO REV. PROC. 2013-30."
Attach a statement indicating that the corporation either had reasonable cause or inadvertently failed to file Form 2553 in a timely manner. Explain the circumstances in detail. Both Form 2553 and the attached statement must be signed by each and every shareholder.
Reasonable cause refers to the specific facts or circumstances that caused the forms to be filed late. "Reasonable cause is based on all the facts and circumstances of your situation," according to the IRS. "We will consider any reason which establishes that you used all ordinary business care and prudence to meet your federal tax obligations but were nevertheless unable to do so. Taxpayers have reasonable cause when their conduct justifies the non-assertion or abatement of a penalty. Each case must be judged individually based on the facts and circumstances at hand."
Be sure to address the following points when you're writing a reasonable cause statement:
- What happened and when did it happen?
- What facts and circumstances prevented it during the period of time that the business entity had not yet filed the forms?
- How did these facts and circumstances result in the forms not being filed on time?
- How did the business entity handle the remainder of its financial and tax affairs during this time?
- What attempt did the business entity make to correct the situation when the facts and the circumstances changed?
When the Business Entity Was Required to File IRS Form 8832
IRS Form 8832 is used by business entities other than corporations that elect to be classified as S corporations for federal tax purposes. A common example is a single member limited liability company. Ordinarily, this type of company would be treated as a disregarded entity. The single member liability company could elect to be treated as a corporation instead, then subsequently elect to be treated as an S corporation.
Sometimes the single member limited liability company does not elect to be treated as a corporation and does not to elect to be treated as an S corporation within the prescribed time frames. Fortunately, the IRS has developed procedures that permit such taxpayers to retroactively file both elections. This procedure also applies to other tax entities, such as associations formed as partnerships and any business entity that would not normally be classified as a corporation for federal tax purposes.
Under this procedure, business entities must request both retroactive classification as corporations and retroactive election as S corporations. The business entity must prepare Form 8832, including Part II, and it must also prepare Form 2553, including the reasonable cause statement in section H of Part I and the required representations found in Part IV.
You can refer to the Instructions for Form 2553, the Instructions for Form 8832, and Revenue Procedure 2009-41 for additional reference material relating to the retroactive relief for both classification as a corporation and S corporation status.