31 Mar S Corporation Requirements
S Corporation Requirements
S corporations (also referred to as “S corps”) are very popular amongst small business owners because they offer those businesses pass-through taxation, and also give the owners of those businesses potential tax benefits through the taking of shareholder distributions (also referred to as “draws” or “dividends”) at reduced tax rates.
New business owners often inquire whether their company can qualify to be taxed as an S corp. There is a lot of misleading, and confusing, information out there about the requirements for such an election. Through this article, I’ll try to explain the requirements in as straightforward a manner as possible.
Before proceeding, though, one common misunderstanding should be addressed: There is no such thing as starting a company as an S corporation; rather a company needs to be started first (also referred to as “incorporating a company”) — whether as a corporation or limited liability company (LLC) — and then the company owners can file Form 2553 with the IRS to elect to be taxed as an S corp. In that regard, there is a distinct difference between choice of entity and choice of tax status.
With that qualification in mind, the following are all of the requirements a company must meet to elect to be taxed as an S corp:
1. It must be a domestic company (i.e., it must be a corporation or LLC incorporated in the United States);
2. It must have only the following types of allowable shareholders: individuals (none of whom are non-resident aliens), estates, certain trusts or certain exempt organizations;
3. It must have no more than 100 shareholders;
4. It must have only one class of stock; and
5. It must not be an “ineligible corporation.”
As to requirement #2, exempt organizations that may be shareholders are described in sections 401(a) or 501(c)(3) or the Internal Revenue Code, and the trusts that may be shareholders are described in section 1361(c)(2)(A). Only citizens or residents of the United States can be shareholders. Some specific examples of individuals or entities that may not be shareholders include partnerships, corporations, non-resident aliens, foreign trusts and traditional or Roth IRAs. However, a parent S corp can elect to treat an eligible wholly owned subsidiary as a qualified subchapter S subsidiary.
As to requirement #3, an individual and his or her spouse (and their estates) may be treated as one shareholder. All members of a family (as defined in Section 1361(c)(1)(B)) and their estates may also be treated as one shareholder. For additional situations in which certain entities will be treated as members of a family, see Regulations section 1.1361-1(e)(3)(ii).
As to requirement #4, in general a company is treated as having only one class of stock if all outstanding shares confer identical rights to distribution and liquidation proceeds. Voting rights can be disregarded.
As to requirement #5, “ineligible corporations” include the following: a bank or thrift institution that uses the reserve method of accounting for bad debts under section 585; an insurance company subject to tax under subchapter L of the Internal Revenue Code; a corporation that has elected to be treated as a “possessions corporation” under Section 936; or a current or former domestic international sales corporation.
If you own an LLC and want to elect to have that company taxed as an S corp, read this article.
If you are interested in electing to become an S corp, or you have any questions about S corporation requirements — especially if your business is in or around Portland, Oregon — please contact us.
Author: Andrew Harris
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