S corporations are small business corporations meeting the requirements of Subchapter S of the Internal Revenue code. An S-corporation is really a hybrid. A C-corporation files an S Election form with the IRS which combines the limited liability advantages of a C-corporation with many of the federal income tax characteristics of a partnership. Essentially, the taxes on profit or loss are paid at the shareholder level instead of at the corporate level. This can produce significant tax savings.
Next to sole proprietorships, S-corporations are being increasingly popular for newly incorporated businesses, as well as existing C-corporations that meet the requirements. In fact, statistics show a greater number of conversions to S-corporations than new incorporations immediately electing the S-corporation election.
Large and public corporations usually can't choose the S election because there has to be no more than 100 shareholders or no more than one class of stock.
Small Business Requirements
The following requirements must be met in order to qualify for a small business eligible for the S election:
- It cannot be a prohibited corporation such as an insurance company, possessions corporation (Puerto Rico), IC-DISCs, taxable mortgage pool, or others;
- All shareholders must be individuals, certain trusts, estates, or qualifying tax-exempt entities;
- Only one class of stock can exist;
- There can be no more than 100 shareholders; and
- No shareholder can be a nonresident alien.
A corporation is eligible to be taxed as an S-corporation only if it qualifies as a small business corporation each fiscal year. Therefore, if you have a rapidly growing business, you must make sure that you continue to qualify for eligibility, or it will fall back into a regular C-corporation status with some unexpected tax results. Not all is lost if this should happen. You can ask the IRS for a waiver and time to fix the problem to bring your business back into compliance - but it is at their discretion to allow the waiver.
Filing the Paperwork
Although creating a corporation is done at the state level, electing to be taxed as an S-corporation is done by filing Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service. The election should be signed by the same person authorized to sign the corporation's tax return and all shareholders on the date of the election must consent to it.
For a new corporation, this should be done within the first 90 days after incorporation to be valid for the year of incorporation. For an existing corporation, it must be filed by the end of the third month of the fiscal year of the corporation to be counted for that fiscal year. If filed after the third fiscal month, the S election will become valid the following year.
While rarely used, other legal entities like sole proprietorships, partnerships, and LLCs can choose to be taxed as an S corporation. The process for this would be to file Form 8832, Entity Classification Election with the IRS, which is an election to be treated as a corporation. And then file Form 2553, to elect to be treated as an S corporation. This course of action is not recommended unless there are sound reasons for it and it is recommended that you consult a tax advisor first.
An S election may be cancelled and the corporate status returned to a regular corporation, but if this is done, there is a five year waiting period until you apply again for the S-corporation status.