At first glance, the corporate tax rules for forming an S corporation appear simple. They are not. Avoid these mistakes when you convert to an S-corp.
Basic Requirements
Here is what your business must look like when it operates as an S corporation:
1. The S corporation must be a domestic corporation.
2. The S corporation must have fewer than 100 shareholders.
3. The S corporation shareholders can be only people, estates, and certain types of trusts.
4. All stockholders must be U.S. residents.
5. The S corporation can have only one class of stock.
Simple, right? But what often appears simple on the surface is not so simple at all.
Don’t Forget Your Spouse
If you live in a community property state, your spouse by reason of community property law may be an owner of your corporation. This can be true whether or not your spouse has stock in his or her own name.
If your spouse is an owner, your spouse has to meet all the same qualification requirements you do. This can raise two issues:
1. If your spouse does not consent to the S corporation election on Form 2553, your S corporation is not valid.
2. If your spouse is a non-resident alien, your S corporation is not valid.
Converting an LLC to an S Corporation
Method 1. To convert your LLC to an S corporation for tax purposes, you can use a method we call “check and elect.” It’s easy—just two steps. First, you “check” the box to make your LLC a C corporation. Then, you “elect” for the IRS to tax your C corporation as an S corporation. Here’s how you take the two steps:
1. File IRS Form 8832 to check the box that converts your LLC to a C corporation.
2. Then file Form 2553 to convert your C corporation into an S corporation.
Method 2. Your LLC can skip the C corporation step and directly elect S corporation status by filing Form 2553.
Loans That Terminate S Corporation Status
Don’t make a bad loan to your S corporation. With the wrong type of loan, you enable the IRS to treat that loan as a second class of stock that disqualifies your S corporation.
Small loans are okay. If the loan is less than $10,000 and the corporation has promised to repay you in a reasonable amount of time, you escape the second-class-of-stock trap.
Larger loans are more closely scrutinized. If you have a larger loan, your loan escapes the second-class-of-stock trap if it meets the following requirements:
1. The loan is in writing.
2. There is a firm deadline for repayment of the loan.
3. You cannot convert the loan into stock.
4. The repayment instrument fixes the interest rate so that the rate is outside your control.
Takeaways
If you want your S corporation staus to hold up in an IRS audit, do two things:
(1) Make sure to follow the above rules.
(2) Have tax pro in your corner to help you do it right.
If you would like to discuss converting to an S-corporation, please contact me by scheduling a call, or by emailing at [email protected].
We specialize in helping clients clarify their taxes so they keep more of their money. Many small business owners who come to see us in Fort Worth, TX generally do not understand the tax law enough to explain it to a fifth grader.
Tatsiana B. Bender
Bender CPA, PLLC
Fort Worth, TX 76107
[email protected]
Phone: (817) 313-4352
Bender-CPA.com
