After a long hiatus from this blog, I decided it was time to revisit S-Corps. If you are unfamiliar with S-Corps, go check out Collin’s first and second posts on S-Corps, which provide helpful context. With the foundation laid for the basics of S-Corps, we can turn to the main focus of this post: electing to be taxed as an S-Corp and maintaining that status.
The election part is relatively easy. File Form 2553 with the IRS. Assuming the form is filled out and filed correctly, the IRS will mail back a letter confirming the company’s designation as an S-Corp.
The maintaining part is the harder one of the two. As Collin mentioned in his post, there are certain requirements that an entity must maintain, such as the number and type of shareholders, as well as a single class of shares. If any of those requirements are no longer met (or were not met from the start), the S-Corp status goes away, and the default taxation method (C-Corp taxation for corporations and partnership taxation for LLCs) returns. What’s more, unless the company is able to persuade the IRS otherwise, the company cannot re-elect to be taxed as an S-Corp until 5 years after the status goes away.
With this in mind, it is important for a company taxed as an S-Corp to be vigilant in avoiding inadvertently losing its status. Oftentimes, companies will put rules in their operating agreement or bylaws that theoretically work as guardrails to prevent the company from losing its status, such as placing a cap on the number of shareholders and only authorizing one class of shares. These are good internal rules to have in place, but a company then needs to follow those rules. Furthermore, if the rules aren’t crafted carefully and taken in the context of the rest of the company’s operations, the end result might still be a loss of the S-Corp status.
For example, a company may think that if their internal rules only allow one class of shares, then they have met the “one class of shares” requirement. However, if that same company nonetheless distributes profits and losses to its owners in a way that is not strictly proportional to each of those owner’s ownership percentage in the company, then there effectively are multiple classes of shares, even if the internal rules do not specifically name them as such. In this scenario, the disproportionate sharing of profits and losses is granting privilege to some owners by subordinating the interests of others, which the IRS views as creating multiple classes of shares.
If you have read this far and are thinking about/have already elected to be taxed as an S-Corp, here are some possible takeaways:
- You don’t need to intentionally violate the S-Corp requirements to violate them. In fact, this post demonstrates that you can unknowingly do it. Good intentions to meet the requirements are wonderful, but solid plans as to how to meet them are better.
- Review your operating agreement or bylaws and make sure that they don’t explicitly allow you to violate the requirements, but also that they provide adequate guardrails to prevent you from going down that path.
- Think about how you are currently running your business. Are you following what your operating agreement or bylaws say? Are your practices violating the S-Corp requirements, even if they seem okay on their face?
- If you are unsure about #2 or #3, talk to your attorney. He or she should be able to sit down with you and go over your operating agreement or bylaws to see if there are any red flags.
Thanks for reading!