Structuring your business as an S Corporation can have its advantages, but it comes with responsibilities.
Becoming an S Corporation can be as simple as making an election on Form 2553, Election by a Small Business Corporation, when the company is formed, or “Checking the Box” on Form 8832, Entity Classification Election, during the life of the business. To make that election, the business has to meet specific requirements spelled out in the Internal Revenue Code (IRC) – they form the definition of a Small Business Corporation:
- The business has no more than 100 shareholders
- All shareholders must be individuals (or other explicitly permitted types of organizations)
- No shareholder can be a nonresident alien
- Only one class of stock is outstanding
So, what happens if you don’t follow all the rules once you become an S Corporation? Just like being grounded for breaking the rules when you’re a teenager, the IRS can revoke your S Election. These triggers are:
- The majority of shareholders elect to revoke the S election
- The business has accumulated profits over 3 consecutive years and passive income exceeds 25% of each year’s gross receipts
- The business is no longer a SMALL BUSINESS CORPORATION
The election by shareholders and the accumulation of profits/passive income are easy to plan for and anticipate. Losing your Small Business Corporation status, however, can be a bit trickier. The most common accidental trigger causing the revocation is from creating a second class of stock. While different voting rights among stocks do NOT create a second class of stock, unequal distributions of corporate proceeds DO create a second class of stock. Governing documents set the organization’s policies; however, if actions are taken causing distributions to differ in timing or amount, a second class MIGHT be created. One example action relates to buy/sell agreements of the organization’s stock – if the purchase price used is significantly different than the fair market value of that stock, you MIGHT have created a second class of stock.
The bottom line of making an S-Election: Know both what the advantages of the structure mean to you and know the responsibilities that must be followed. The best way to ensure your election is not revoked is to have a trusted accounting team ready to research the solutions you need – the solutions that support your company’s specific financial goals.
References:
Internal Revenue Code, Section 1361, S Corporation Defined
Internal Revenue Code, Section 1362, Election, Revocation, Termination
Treasury Regulations, Section 1.1361-1, S Corporation Defined
