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Nuts and Bolts of the S Corp Election
By Jason Watson, CPA
Posted Tuesday, October 31, 2023 (boo!)
Let’s take a step back and talk about some of the underpinnings of the S corporation election. Some of this is boring legalese and some of this is nerdy accountant-ese, but you’ll be better for it. Perhaps.
Treasury Regulations Section 301.7701 discusses all sorts of things about business entities and the default tax classification. The IRS website has a nice summary-
A Limited Liability Company (LLC) is an entity created by state statute.
Depending on elections made by the LLC and the number of members, the IRS will treat an LLC either as a corporation, partnership, or as part of the owner’s tax return (a disregarded entity).
A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and elects to be treated as a corporation.
For income tax purposes, an LLC with only one member is treated as an entity disregarded as separate from its owner, unless it files Form 8832 and elects to be treated as a corporation. However, for purposes of employment tax and certain excise taxes, an LLC with only one member is still considered a separate entity.
This simply means that unless you do something extra (which the IRS refers to as Check the Box elections), you will default to the tax classification above. Therefore, and as summarized by the IRS above, three possible tax classifications exist for business entities- corporation, partnership or disregarded entity. As we’ve discussed elsewhere, community property states usually follow the single member LLC disregarded entity rules above.
Treasury Regulations Section 301.7701-2 expands this a bit and defines business entities separately from corporations. We’ll move along unless you are starting a bank or insurance company.
Form 8832 allows you to change the tax classification of an entity. Treasury Regulations Section 301.7701-3(g)(1) outlines the various re-classifications, and we’ve summarized them here-
- Partnership to an association (corporation). The partnership contributes all of its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter, the partnership liquidates by distributing the stock of the association to its partners. Woohoo!
- Association (corporation) to partnership. The association distributes all of its assets and liabilities to its shareholders in liquidation of the association, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership. Exiting!
- Association (corporation) to disregarded entity. The association distributes all of its assets and liabilities to its single owner in liquidation of the association. Riveting! This would be the aftermath of revoking an S Corp election and electing the association to now be taxed as a single-member LLC.
- Disregarded entity to an association (corporation). The owner of the eligible entity contributes all of the assets and liabilities of the entity to the association in exchange for stock of the association. Neat! This would be part of the process of electing S corporation tax status (more on this in a bit).
Is Form 8832 necessary when electing S Corp tax status? No. In fact, you should avoid filing Form 8832 if your true intent is to be taxed as an S corporation. Why? If you file Form 8832 and the IRS accepts that, you are now going to be taxed as a corporation. If you then file Form 2553 and that is rejected for whatever reason, you are stuck with being taxed as a corporation. This is not the worst thing on the planet; the Bears winning a Superbowl naturally is. However, this “8832 no man’s land” is certainly an avoidable annoyance.
Rather, if you only file Form 2553 and that is rejected for whatever reason, your tax classification remains as-is. Want to know more? Of course!
Treasury Regulations Section 301.7701-3(c)(1)(v)(C)… yeah… way deep into the indentation… states in part (we saved you from some of the extra verbiage)-
An eligible entity that timely elects to be an S corporation under section 1362(a)(1) is treated as having made an election under this section to be classified as an association.
Ah! This basically says that if you have an eligible entity and you timely file Form 2553, you will be treated as making the election to be classified as an association (corporation) alongside being taxed as an S Corp (a two-fer if you will). Don’t get freaked out about the “timely elects” part. As discussed, IRS Revenue Procedures 2013-30 allows for late S corporation elections and as such considers them timely if certain rules are followed.
Tax Free Transfer
The transfer between LLC and association (corporation) is tax free of course unless the LLC’s liabilities exceed its assets. Additionally, IRC Section 351(a) applies which generally states, “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation.”
Don’t get too hung up on the control piece. For most small business owners, this is not a big deal. However, the liabilities exceeding assets part can be a trap especially if you fully depreciated an asset while having a loan (think automobile). If this applies to you, please consult with us.
An election is considered timely if filed within 15 days and two months of January 1 or the entity’s activation. Activation is the earliest date of an entity having shareholders / members (owners), acquiring assets or begins conducting business.
Completing Form 2553 for the S corporation election is straightforward. The form asks for basic business information such as name, EIN, date of incorporation (activation date) and date of election. Keep in mind that this form was built for a C Corp electing to be taxed as an S Corp, so some of the form boxes use words like “incorporation.” LLCs are not incorporated; rather they are usually formed or organized depending on your state’s nomenclature.
It also requires signatures from all owners. Again, the form references shareholders, but an LLC has members. Don’t get too hung up on this, but please understand some of the subtleties. For sanity, members = shareholders = owners. Additionally, use ownership percentages rather than shares.
Another way to view the references to incorporation and shareholders is to recall that as Form 2553 is being processed and approved by the IRS, the entity’s classification is changing to association (corporation) as it is also being taxed as an S Corp (Treasury Regulations Section 301.7701-3(c)(1)(v)(C)).
If your LLC has an existing Operating Agreement, it might need to be amended or restated so it aligns with your entity being taxed as an S corporation. We can help guide you on this. We will also explore ineffective S corporation elections because of problems generated by Operating Agreements.
If you are using a corporation (C Corp or Professional Corp), a corporate resolution might need to be drafted and signed allowing for this tax election. However, Form 2553 references this implicitly within the signature blocks of each shareholder.
Five states require a separate S corporation election form to be filed- Arkansas (really?!), New York, New Jersey, Ohio and sometimes Wisconsin. Generally nothing needs to be done with your state’s Secretary of State in terms of notification or housekeeping stuff.
If you live in a community property state such as Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin your spouse might need to sign the Form 2553 even if he or she is not an owner.
Side bar: Community property laws originate from Spanish property laws which is why most of our bordering states are community property states (red does not mean Republican). Wisconsin has no excuse, and Idaho was just caught in some peer pressure from Washington and Nevada.
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