Understanding the Subchapter S Election
Tax Law Series
By Adrienne B. Haynes, Esq.
Managing Partner, SEED Law
There is a lot of misinformation out there about the Subchapter S election. When starting your business, you may start to hear people say that they have an “S Corp”. It’s a common answer that I get when I ask business owners what kind of business entity they have and I understand the confusion!
First, there is a difference between an entity type and a tax status. An entity type is the statutory form of your business as defined by your state’s statutes. The most common entity types are limited liability companies, partnerships, and corporations. Review our choice of entity article for more information. For tax statuses, this refers to how to IRS will treat your business for federal tax purposes. The IRS outlines four primary tax classifications for companies- a disregarded entity, partnership, corporate options, and tax exempt. An S Corp is one of the allowable corporate tax status options.
Second, let’s understand the available corporate tax statuses. A corporation typically has double taxation — the taxable earnings made is assessed a tax at the corporate level (tax rate) and AGAIN when the money is distributed to its owners or shareholders through federal income tax. There are two options for corporate tax status, C Corp (traditional) and S Corp (Subchapter-S small business election).
With a C corporation, the taxable earnings have double taxation as outlined above. Since no one loves paying double taxes, the entities that typically use this status are those that are traditional corporations.
With an S Corp election for a tax status, entities are able to avoid the majority* of the double taxation and pass-through the corporate income, losses, deductions, and credits through to their shareholders. Limited liability companies are entities that can taxed as a disregarded entity, partnership, or can elect to be taxed as “small business” corporation using this option.
* Note: This does not avoid all double taxation and some taxes may still be assessed on the entity level.
Third, there are specific conditions and timelines to be eligible for the S Corp election.
To qualify for S corporation status, the entity must meet the following requirements:
· Must be an eligible domestic corporation (based in the United States, list of eligible corporation types)
· Only have allowable shareholders (US citizens or resident alien natural persons, some trusts, estates)
Have no more than 100 shareholders
If an entity meets those qualifications, the Subchapter S “check the box” election is made on Form 2553. This form is due to the IRS:
· No more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or
· At any time during the tax year preceding the tax year it is to take effect.
There are some remedies available for making this election outside of the recommended timeline and the Form 2553 instructions provide detailed information.
Fourth, this is a major business decision. If these qualifications are met and an S Corp election is made, it will require business operations updates. Some of these changes could include converting the owner(s) to W2 employees and a change in available tax deductions, If you are an LLC, the IRS provides an overview of possible tax repercussions for changing your tax status.
To convert away from an S Corp election, it requires another communication with the IRS to revoke the election. To revoke the S Corp Election, a statement of revocation must be submitted.
Finally, tax law is complex. This article is only an overview of C Corp and S Corp considerations and is not intended to cover every legal right or obligation, consideration, exception, or restriction. These decisions are require personal considerations and should be well researched and discussed with financial and legal professionals before being made.
To schedule a consultation with a SEED Law attorney, you can give us a call at (816)945–4249 or schedule your consultation today here.
About Form 2553, Election by a Small Business Corporation, https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc (last visited Apr 22, 2020).
Limited Liability Company (LLC), https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations (last visited Apr 22, 2020).
LLC Filing as a Corporation or Partnership, https://www.irs.gov/businesses/small-businesses-self-employed/llc-filing-as-a-corporation-or-partnership (last visited Apr 22, 2020).
Publication 3402 (03/2020), Taxation of Limited Liability Companies, https://www.irs.gov/publications/p3402 (last visited Apr 22, 2020).