Understanding S-Corporations: Basics and Key Considerations

Table of Contents

• What Is an S-Corporation?
• Making and Maintaining the S-Election
  • Rules for Making the S-Election:
• Key Benefits of an S-Corp
• Common Pitfalls to Avoid
• Consequences of Invalid S-Election or Loss of Eligibility Status
• Compliance Requirements
• How We Can Help

S-Corporations (S-Corps) are a popular choice for small business owners seeking to combine the benefits of pass-through taxation with liability protection.

However, choosing and maintaining S-Corp status requires careful consideration of both the initial election process and ongoing compliance with IRS rules.

Here, we explore the fundamentals of S-Corps, rules for electing and maintaining S-Corp status, and scenarios where an S-Corp may be the right choice.

What Is an S-Corporation?

An S-Corp is a tax designation available to certain entities that meet specific IRS criteria. Unlike a traditional C-Corp, an S-Corp allows profits, losses, deductions, and credits to pass through to shareholders, avoiding double taxation.

This structure is particularly appealing to small businesses and startups, as it provides the tax benefits of a partnership with the liability protection of a corporation.

An S-Corp designation does not dictate the entity’s legal structure. For example, LLCs can elect to be taxed as S-Corps while retaining their flexible legal structure.

This distinction is important for businesses to evaluate their tax options and operational needs. Choosing S-Corp taxation often makes sense for LLCs that wish to minimize self-employment taxes on owner earnings while still benefiting from pass-through taxation.

Making and Maintaining the S-Election

Rules for Making the S-Election:

• To elect S-Corp status, a corporation or eligible LLC must file Form 2553 with the IRS, signed by all shareholders, no later than two months and 15 days after the beginning of the tax year when the election is to take effect.
• The entity must meet specific eligibility criteria, including having no more than 100 shareholders, issuing only one class of stock, and ensuring that all shareholders are U.S. citizens or residents.

Maintaining S-Corp Status: To retain S-Corp status, the entity must continue to meet eligibility criteria. Violations, such as exceeding the shareholder limit, issuing a second class of stock, or having an ineligible shareholder, can result in the loss of S-Corp status or invalidation of the election.

Key Benefits of an S-Corp

1. Pass-Through Taxation: Avoids double taxation by passing income, deductions, and credits directly to shareholders.
2. Liability Protection: Shields owners from personal liability for business debts and obligations.
3. Tax Savings: Reduces self-employment taxes on distributions while still allowing reasonable salaries for owners.
4. Flexibility for LLCs: Offers the tax benefits of an S-Corp while preserving the operational advantages of an LLC.
5. Lower State Taxes: In certain states like California, taxes on S-Corps are reasonable. California imposes a 1.5% franchise tax on net income, with a minimum tax of $800 annually. Newly incorporated or qualified corporations are exempt from the annual minimum franchise tax of $800 for their first year of business. For small businesses not planning to raise capital through public or private investors, the S-Corp structure offers significant tax advantages while maintaining simplicity in ownership and management.

Common Pitfalls to Avoid

1. Potential Gain Recognition for Property Contributions:

A new member contributing property to an LLC that has elected S-Corp status may recognize taxable gain as though the property were sold to the LLC. Unlike partnerships, where Section 721 allows property contributions without immediate tax consequences, S-Corps must meet the 80% control requirement under Section 351 to avoid gain recognition.

For example, if a new member contributes clients (represented as goodwill with no tax basis) in exchange for a 10% membership interest in an LLC taxed as an S-Corp, failure to meet the 80% control threshold would result in taxable gain.

2. Potential Gain Recognition at Time of Election:

The tax treatment of a change in classification of an entity for federal tax purposes is determined under the Internal Revenue Code and general tax principles. For LLCs electing S-Corp status, it is critical to ensure that liabilities do not exceed the adjusted tax basis of the assets to avoid gain recognition.

3. Eligibility Violations:

• More than One Class of Stock: Exceeding shareholder limits or issuing a second class of stock can terminate S-Corp status.

For LLCs electing S-Corp status, operating agreements should not include provisions such as liquidating preferences or capital accounts that violate the one-class-of-stock requirement. References to capital accounts and non-proportional liquidating distributions should be removed.

• Foreign Investors: Having a foreign shareholder invalidates the S-election.

Consequences of Invalid S-Election or Loss of Eligibility Status

If the entity was never eligible for S-Corp status (e.g., due to operating agreement violations), the election is considered invalid. This means that the LLC reverts to its default tax classification, typically as a partnership or disregarded entity, and retroactive adjustments and penalties may apply.

If the entity loses its eligibility after electing S-Corp status (e.g., due to a foreign investor acquiring shares), the S-election is terminated. From that point, the entity is treated as a C-Corp and subject to double taxation.

To regain S-Corp status, the entity must rectify the issues and wait five years to reapply, unless the IRS grants specific relief for inadvertent termination.

Compliance Requirements

S-Corps are required to file Form 1120-S annually with the IRS to report income, deductions, and shareholder distributions. Shareholders must include their share of the S-Corp’s income, losses, and deductions on their individual tax returns using Schedule K-1. Compliance also includes:

• Filing payroll tax forms such as Forms 941 and 940.
• Paying reasonable salaries to shareholder-employees to avoid IRS scrutiny.
• Adhering to strict filing deadlines, including March 15 for Form 1120-S, unless an extension is filed.

How We Can Help

Our team specializes in helping businesses evaluate whether an S-Corp is the right choice, and navigate the election process. From filing Form 2553 to ensuring ongoing compliance with federal and state rules, we provide expert guidance tailored to your unique needs. Let us help you unlock the benefits of an S-Corp while avoiding common pitfalls.