What Terminates an S Corp Election?
What Terminates an S Corp Election?
If you own a closely held, small to medium-sized business entity and want to avoid the heavy burden of extensive self-employment taxes, it might be wise to register your business as an S-Corp under sub-chapter S of the revenue code. Now, you might be wondering what the heck that means. In fact, you’re probably perplexed by the mysterious S-Corp altogether. What’s the difference between a regular corporation and an S-Corp and how will it save you money? What’s more, what must you do to avoid inadvertently terminating your S-Corp Election? Let’s look at a quick overview of an S-Corp and why so many small businesses choose to utilize its tax status.
An Overview of the S-Corp
An S-corp is a pass through entity that holds a tax status where shareholders are also employees, and only subject to one level of tax. In other words, the business itself does not get taxed and the owner or shareholders are considered employees of their own business. They get paid a salary just like a regular employee, but the income made beyond what is considered a “reasonable salary” is not subject to Social Security or Medicare taxes. Instead, revenue beyond that of a “reasonable salary” for each shareholder is taxed at the shareholder’s regular income tax rate. In contrast, the profits generated by a C Corporation would be subject to income taxes at the corporation level making any withdrawals from that profit subject to income taxes at the personal level as well – so the profits generated by a C Corporation would be double-taxed: once at the entity level and once at the personal/owner level. Added to that, profits generated by an LLC operated as a sole-proprietorship (reported on a Schedule C on the owner’s personal return) would be subject to income taxes and self-employment taxes.
For a growing business, these additional taxes can take a big toll. However, just as the invisible hero Clark Kent hides the true identity of Superman beneath a suit and tie, saving countless lives along the way, the S-Corp is the “super” corp tax status that saves small businesses from forking out loads of money that, with an S-corp election, could be invested elsewhere. So the S in Superman and the S in S-corp might not stand for the same thing exactly, but an S-Corp truly can “save,” just like Superman.
S-Corp Rules and Regulations
“With great power comes great responsibility.” Spiderman’s Uncle Ben was right. In the world of tax status, “with great benefits comes great responsibility.” Sure, S-Corps and superheroes might not have much in common, yet, here again, S-Corps are comparable to the world of superheroes (if only slightly). Just as superpowers require extra caution, an S-Corp’s benefits are not without restrictions and regulations. By following the guidelines, you can ensure that your business will definitely save money on taxes as an S-Corp. Make sure you are meeting these guidelines to maintain status as an S-Corp:
All shareholders and investors must be citizens or resident aliens of the United States. Though plenty of businesses have foreign investors, an S-Corp cannot.
Less Than 100 Shareholders
It helps to think of the “S” in S-Corp as standing for the word “Small”. Therefore, it would probably be unfair if a company with more than 100 shareholders was able to use a loophole to get out of paying a substantial amount of money towards taxes. If you want to keep your S-Corp status, don’t surpass the double digits.
Make Sure to Have Just the Right Shareholders
Individuals, estates, and certain trusts can all take part as shareholders in your business. Other business entities, like partnerships, LLCs, or corporations, cannot.
S-Corps Are Limited to One Class of Stock
With multiple shareholders, it’s more common to have different stock options. With one class of stock, profits and losses are allocated proportionately to shareholders, without any preferential treatment towards one shareholder over another.
Have an Eligible Business for S-Corp Classification
Insurance companies, financial institutions, and domestic/international sales distribution corporations are not eligible to be shareholders in companies with S-Corp tax status.
Involuntary Termination of S-Corp Status
By adhering to the requirements of S-Corp status, you should be able to avoid an involuntary termination of your S-corp. Only by “breaking the rules”, such as allowing a second class of stock or including an ineligible shareholder, will you be subject to S-Corp termination. In addition, if your business has subchapter C earnings and the passive income exceeds what was set as the passive income limitation, you could be facing involuntary termination of your business’ S-Corp status. If passive investment income exceeds 25% of gross receipts for three consecutive years, S-Corp status will be terminated. An S-Corp that does not have subchapter C profits has no passive income limitations, and will not be terminated regardless of the percentage of passive income.
An S-Corp election is terminated the day the company has triggered its ineligibility. If a corporation is terminated from its S-Corp status, that corporation will not be eligible to elect S-Corp status again for another five years. On the flip side, once a company has registered as an S-Corp and is subsequently approved, it cannot change its tax election for five years. The decision on either side of the spectrum are long-haul commitments, whether voluntary or involuntary.
If an S-Corp is terminated, the company involved should include a notice of the termination and the date it occurred in the tax return for that business year. Even if your S-Corp does meet its fiery end with inadvertent termination, there is some glimmer of hope:
Relief for Terminated S-Corp
There is a chance that the IRS will be merciful in the event that your company’s S-Corp status is terminated and revoked. However, your company must be able to prove that the termination was indeed involuntary. With an IRS-approved waiver, a corporation can restore its S-Corp status. By demonstrating that your corporation made an inadvertent act, and by taking the steps to correct the terminating act within a reasonable amount of time, you can reap the rewards of the IRS’ mercy. Also, all shareholders involved at the time of termination must agree to take the steps necessary to restore S-Corp tax status. The IRS must be able to determine whether the termination cause was indeed involuntary, that is, something that is not necessarily within reasonable control of the company. A common S-Corp “end all” is distributing shares disproportionately, which can be thought of as creating a second stock.
Overall, an S-Corp election can bring you and your company wonderful benefits! By staying in check with the rules and regulations of your S-Corp election status, you should have no problem maintaining an S-Corp. As an S-Corp, you will save money as your company’s profits are not fully subjected to the high-rate self-employment taxes. If you’re ready to make an S-Corp election, let The Watson CPA Group help. Our knowledgeable team will make sure all your questions are answered so that you know you’re making the right decision. Contact us today, and we’ll get you on the road to savings in no time!