Formation (Election) of an S-Corp
There is a misconception floating around out there that an S-Corp is a standalone entity. Not true. There are several entity types, but the three most common are:
- Limited Liability Companies (LLCs), either as a single member or multi-member
- Partnerships, including all the variants (LP, LLP, LLLP, etc.), and
- Corporations (C-Corps), including Professional Corporations (PCs).
Each can elect to be treated as an S-Corp for taxation purposes under subchapter S of the revenue code.
So while we might talk about your “S-Corp”, we are truly talking about your LLC, partnership or C-Corp being treated as an S-Corp for taxation. While there are partnerships and C-Corps out there who elect to be treated as an S-Corp, this book generally focuses on the “S-Corp LLC” where the underlying entity is an LLC being taxed as an S corporation. However, the information is valid for each entity type.
Also, the words member and shareholder are synonymous as well from a conversational perspective- the state considers owners to be members but the IRS considers the owners to be shareholders when issues like distributions, basis, etc. Same is true for equity accounts on the balance sheet.
Electing S-Corp Filing Status, Retroactive for 2017
Yes, you are able to engage in revisionist history and retro activate your S Corporation election to January 1 and have your income avoid a large chunk of self-employment taxes. Which year? Good question, and Yes, of course, it depends. First things first. You must be eligible to become an S-Corp for taxation purposes-
- you must have an LLC, partnership or C-Corp already in place,
- your entity must be domestic,
- have 100 or fewer shareholders,
- have shareholders who are individuals, estates or exempt organizations, and not have any non-resident alien shareholders, and
- have only one class of stock (you are allowed to have voting and non-voting as one class)
There are some other devils in the details, but 99% of the LLCs, partnerships and C-Corps out there qualify.
Late S Corp Election
Form 2553 (the S-Corp election form) must be filed with the IRS. It is typically due within 75 days of forming your business entity or March 15 of the following year. However in typical IRS fashion there are 185 exceptions to the rule and the late S corporation election is another example. The IRS provides relief for the late filing of Form 2553. Historically, IRS Revenue Procedures 2003-43 and 2004-48 used to be the governing rules but the IRS has simplified it (imagine that!).
IRS Revenue Procedure 2013-30, effective September 3 2013, allows an entity to get relief and elect S-Corp status within 3 years and 75 days from the date the election was originally intended to be effective. The IRS is basically saying that if you walk and smell like an S-Corp, then you are an S-Corp.
So, if it is November 2017, and you want to go back to January 1 2017, no problem. If it is March 2018 (tax season) and you are freaking out because you forgot to make the election earlier, you can still go back to January 1 2017. No that is not a typo… we are talking about going back to the previous year’s January 1!
There are hiccups. Isn’t hiccups such a friendly word? Sort of like bumps in the road. Bruises is another word that is about as hollow as hiccups and bumps. No one says pitfalls or disasters anymore, just hiccups. Bottom line is we can engage in some revisionist history on March 1 2018 and create a payroll event for December 31 2017. No worries.
If your current CPA or tax professional says no, I suggest you find a new accountant. Scripps Financial Group has been doing this for over a decade (there was relief provisions prior to the 2013 IRS Rev Proc as well) without major problems. You might incur some late filing penalties which sometimes can be abated under the First Time Abatement statutory relief program. We will review on a case by case basis.
Once the facts and circumstances are reviewed and everyone thinks the S Corp election is the way to go, there are three things that happen simultaneously-
- File S Corp Election Form 2553 to the IRS, Fee: $275(one time fee)
- Open & Setup Payroll Accounts, Fee: $350 to $450 (one-time fee)
- Issue a 1099-MISC as Officer Compensation (in lieu of a late payroll), Fee: $350 (this includes tax planning and estimated tax calculations)
- Prepare S Corporation Tax Return on Form 1120-S, Fee: $1150 (can be higher if your records are in need of fixing)
So about $2,200 give or take a few bucks however you will be saving anywhere from 8% to 10% of your net business income depending in your situation. Also remember that the late S Corp election and payroll account setup is a sunk cost. In other words, you would need these things done regardless of late S Corp election for the previous year or waiting until next year. Bite the bullet now. Get it done.
In the past, to obtain relief with a late S-Corp election during the tax season, we would prepare and file Form 1120S (corporate tax return) and attach Form 2553 (S-Corp election) to it. Today, there are two paths. If we can file the S Corp tax return (Form 1120S) by March 15, then we send off the Form 2553, wait for the IRS to approve and then eFile the tax return. New school.
Conversely, if we cannot file the tax returns in a timely manner, we usually have to paper-file the tax returns along with Form 2553. This is the old school way and there are times it is the only way.
Everyone once in a while the IRS loses its mind and rejects the late S Corp election. We always get it pushed through. Always. Unfortunately the rejection or some other nasty gram of a notice arrives on your doorstep at 5:01 pm on a Friday. Briefly freak out, send the documents to me, and then have a margarita- it’ll be OK.
At the very worst we have to obtain a Power of Attorney from you, call the IRS and give them a “see… how it works is…” spiel. Your mileage might vary, but I may be able to get your late payment penalties abated with the IRS. Each state is different, and some are unsympathetic. Again, the savings will outweigh the costs (or Iwouldn’t let you do it).
Missing Payroll, Now What?
There is a near certainty that we can make the S Corp election retroactive to January 1 of 2017. As mentioned earlier, one of the pillars of S Corps is to pay a salary to the shareholders.
If it’s 2018, and 2017 is all over, there are three options (in descending order of elegance)...
1. Issue a 1099 to Yourself
Really?! For real? What we can do is issue a 1099-MISC for a portion of the company net income to yourself which will be reported on Schedule C of your personal tax return. In turn, this income will be subjected to self-employment taxes. Remember self-employment taxes and Social Security and Medicare taxes are the same thing.
The amount of the 1099-MISC is entered into Line 7 of Form 1120S as Officer Compensation. Therefore from an Officer Compensation to net business / K-1 income comparison, this technique still satisfies the reasonable salary sniff.
While the IRS might frown upon this option, at the end of the day they are typically satisfied since employment taxes are essentially being paid. Again, this is not as elegant as the W-2 option, but it certainly works for the first year.
Additionally, if you were to lose an IRS challenge on reasonable salary determination the IRS would impute income on Schedule C. We are simply following what they would eventually do anyway. Again, this is a first-year mulligan. A one and done. Payroll must be set up for the following year, and normal W-2 and other filings must be done.
2. Reclassify Distributions as Wages
Submitting a late payroll event is too time consuming and not really advisable. I list this option in case you or someone else wants to run a late payroll after December 31, but if you want to see a flurry of IRS and state notices, and waste time wading through it all, then go for it.
3. Roll the Dice
As paid tax professional, Scripps Financial Group cannot advise this course of action. Having said that, I have observed several taxpayers labeling the first year as a mulligan, not creating a W-2 or a 1099, and taking his or her chances. Audit rates are about 0.4% for S-Corps, and currently the Treasury Inspector General of Tax Administration (TIGTA) is charging the IRS with the task of auditing S-Corps that do not pay a salary and who report losses for three or more years. As a result, profitable S Corps appear to be flying under the radar especially if you only miss one year of paying a salary (your first year).
What could happen? The IRS could simply impute wages, create payroll liabilities and send you a bill. We’ve seen S Corporations get these types of notices. This is not ideal since the state is not getting its share of things such as unemployment and disability, and the IRS is sharing data with states.
Though you could escape the IRS laser, rolling the dice is not my professional advice, nor the way I practice. If this is something you want to do, I will simply decline the engagement.
Huge Emphasis: I cannot stress enough that having an LLC in place is cheap insurance even if you don’t ever elect to be an S Corp. While IRS guidance is hazy, it our recommendation plus the recommendations of tax attorneys and other consultants that the effective date of the S Corp election should not occur before the earliest date that the LLC has members, acquires assets or begins conducting business.
Let's say it's mid July and your income or sales have really gone up so we decide that the S corporation election is the way to go. We don’t go back to Q1 and Q2, and run late payroll. That is an unnecessary can of worms. We simply open payroll accounts for Q3, determine your reasonable salary, compute your tax obligation and chop it up between Q3 and Q4.
No, the IRS does not get alarmed when you start payroll in the middle of the year. No, they are not concerned about the lopsidedness of your payroll. Yes, there might be some underpayment penalties if you haven’t made any estimated tax payments.
Nuts and Bolts of the Election
Behind the scenes there are some technical things going when electing to be an S-Corp. The LLC essentially transfers all of its assets and liabilities to the corporation in exchange for the corporation’s stock and then distributes stock to its shareholders to complete the liquidation. Sounds cool. Read IRS Regulations Section 301.7701-3(g)(1) if you can’t get enough.
The transfer is tax free of course unless the LLC’s liabilities exceed its assets. If this applies to you, please consult with us. Also, Form 8832 Entity Classification Election is generally not required since the Form 2553 S-Corp Election supersedes it.
If you have an existing Operating Agreement it will need to be updated so it aligns with your entity being taxed as an S corporation. I can help guide you on this.