The Subchapter S corporation remains a popular choice of entity for small and medium-sized businesses. This is true even after the TCJA of 2017 lowered the income tax rate for C corporations to 21 percent. Unlike many other changes made by the TCJA, the 21 percent flat corporate rate is permanent. It is not going to sunset in 2025 as other provisions will.
The lower individual income tax rates combined with the Sec. 199(a) deduction for individual tax returns of business owners has helped some S corporation owners in the past couple of years. With the individual income tax rates that were lowered due to the TCJA set to expire in a few years and the Biden administration proposing higher individual income tax rates, it may be time to do a little tax planning and consider whether to make changes to tax elections such as the S corporation election.
For many, this may include going back and making late S corporation elections. Given the recent uptick in S election rulings the IRS has been issuing, such as the recent PLR 202236003, it is helpful to consider when a late S corporation election can be made.
About Subchapter S Corporations
The S Corporation is usually established to minimize self-employment tax that would otherwise be due and owing on the net business profits received by the owners. There are other reasons too, such as value freeze transactions, the ability to trigger and time losses, etc., but self-employment tax savings is likely the most common reason for making S corporation elections.
The self-employment tax savings comes from the ability to divide the net business profits into wages and distributions. The wages paid to the owner are subject to income and payroll taxes. The owner’s wages are deducted against the business income and thereby reduce the amount of the remaining business profits that are reported on the owner’s individual tax return. Thus, the owner reports the wages and the remaining business profits on his or her individual income tax return. The business profits are subject to income taxes (even if they are not distributed to the owners and even if the distribution is just the use of the business property for personal use), but they escape payroll and self-employment taxes.
As the owner of the business, the owner is able to set the amount of wages they are paid. The IRS will usually accept this amount as long as it is reasonable. There are a number of disputes involving S corporation owners who failed to pay themselves a reasonable salary to avoid self-employment or payroll taxes.
This benefit can be offset by the cost of filing the Form 1120S and/or Forms 941 (for payroll), the impact on other tax attributes (such as the Sec. 199(a) deduction and the research tax credit), and the 2 percent shareholder rules that limit certain business deductions for S corporation owners. These and other factors have to be considered in deciding whether to make an S corporation election.
Making the S Corporation Election
A legal entity, be it a corporation or an LLC, can make an election to be an S corporation. The election is made on Form 2553.
If the shareholders live in a community property state, like Texas, both spouses have to sign the Form 2553.
The form can be filed with the IRS directly or submitted with the first tax return. The S corporation files a Form 1120S, so the form can be submitted with this return (or the form to request additional time to file the tax return). The return has a box to check to note that the Form 1120S is a first year return. We’ll come back to these rules in the next section.
Before moving on, we should note that there are other steps that have to be completed when making an S corporation election. For example, for LLC’s, the Form 8832 usually has to be filed first. This form converts the LLC to a C corporation and the C corporation can then make the S corporation election.
The corporation documents also have to be updated. One of the requirements for the S corporation is that distributions are made according to the amount of stock held (or LLC interest ownership percentage if it is an LLC). Becuase of this, the entity also has to update its By Laws and/or Articles of Orgnaization (if it is a LLC in Texas, it’s Company Agreement). This has to be done to ensure that the entity complies with the equal distribution requirement for S corporations.
Timing of the Subchapter S Corporation Election
This brings us back to the timing rules. Taxpayers can make an S corporation election effective for the current tax year or, in some cases, effective for prior tax years.
For new entities that want to be a S corporation from the start, the Form 2553 has to be filed within 2.5 months of the date the entity was formed. If the entity was already in existence, it can file the Form 2553 within 2.5 months of the start of the next year. These are referred to as tiemly-filed S corporation elections.
S corporation elections can also be made late. Specifically, taxpayers can file the Form 2553 for any date (that they list on the form as the effective date), as long as it is filed within three years and 75 days of the date listed as the effective date. These elections are referred to as late elections. The late election generally requires the taxpayer to go back and file Forms 1120S and payroll tax returns (if they had not already been filed) for the prior year periods.
The Form 2553 has a shareholder consent section that the shareholders have to sign to confirm that they have reported their income for these prior years consistent with an S corporation election. There is also a section to explain why the taxpayer had “reasonable cause” for not filing timely. A simple statement about not knowing the requirement to file is usually sufficient.
Taxpayers should note that the IRS will also assess late filing penalties for the Forms 1120S and payroll tax returns. These penalties can be several thousand dollars. Luckily, taxpayers often qualify for the IRS’s “first time abate” policy and can have the penalties removed by calling or writing the IRS to ask that they be removed.
The Really Late S Corporation Election Request
Those who did not previously file their individual income tax returns consistent with the entity being an S corporation can still make a late election within the 3 years and 75 day rule. This is often the case where there is no reasonable cause for the late filing or the shareholders did not report the income and expense consistent with the business being taxed as a S corproation.
These really late S corporation elections are made by requesting a private letter ruling request under Rev. Proc. 2021-1, 2021-1 I.R.B. 1. Despite comments that it would no longer make these types of rulings, the IRS is still making these rulings. PLR 202236003 is a good example.
Those making these really late S corporation elections should know that a private letter ruling request, even if granted, does not relieve the taxpayer from any late filing penalties. So while the taxpayer benefits by being able to get the benefits of a S corporation, the IRS is likely to send the taxpayer a notice imposing penalties when the taxpayer files the late Form 1120S returns with the PLR attached.