There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.
Jeremy Wells: The S Corporation can be a powerful tax reduction strategy for some self-employed taxpayers. In fact, it's become such a popular strategy that there's a ton of content out there on the internet, blogs, videos. Some of that from influencers, [00:00:30] some of that from actual tax professionals. That includes a lot of information, some of it good, some of it not so good. A lot of it misconceptions about who should elect s when and how. In this episode, I'm going to break down exactly how to make an selection, what to do if the entity wants to make a late s selection and how to handle that situation, and then how to advise business owners who think [00:01:00] they need an S election. It's absolutely critical as tax professionals, when we're working with self-employed people who are considering an S selection, that we understand, not just the immediate effects of making that election, but that we also understand all of the potential repercussions that can happen downstream, that can happen in future years, that can happen if that business owner wants to make certain decisions about their business. All of those questions, all [00:01:30] of those planning considerations are going to come into play when thinking about that election. And once that election is made, it will have lasting consequences for that business. And it's important to keep all of that in mind as we're advising taxpayers. Now, if you're a small business owner listening to this episode, then it's especially important that you understand these repercussions.
Jeremy Wells: But regardless, I strongly recommend working with an experienced and qualified [00:02:00] tax professional before you make any kind of entity selection decisions. So in this episode, we're going to make sure that we fully understand what an selection is, how to make it, and how that affects a small business that makes that election. So we're going to look at identifying the requirements for an entity to elect s corporation. What makes an entity even eligible to elect an S corporation and what needs to be [00:02:30] true of its ownership, especially we're going to assess whether an entity qualifies for relief for a late s election. Again, I see a lot of discussion about making a late selection, and there's a lot of misconception about not just the process of going about making that late election, but whether it should even be made in the first place. And then finally, we're going to evaluate whether an entity and its owners would actually benefit from an S [00:03:00] corporation. There is one factor that is especially important, and that's the one that tends to get all of the attention when it comes to making an S selection, but it is by no means the only factor. And in fact, if we focus too strongly on one factor when it comes to making an selection and ignore the other factors, then actually we could be doing the wrong thing. We could be making a bad decision for that business and its ownership. So let's start with [00:03:30] the technical specifications of how to make an selection.
Jeremy Wells: This is a process that seems straightforward, but it can be tricky. There can be some issues along the way with making the election. So let's start off with the requirements to elect S for a business. In order to elect s, there first has to be an entity. There needs to be a qualifying entity that can actually make that [00:04:00] election. That entity has to meet certain requirements. First of all, it has to be a domestic corporation or domestic eligible entity. That's the way it's defined in IRC section 1361 B1, a domestic corporation or domestic eligible entity. Now we're going to talk later about what most commonly happens. And that is actually a limited liability company or an LLC choosing [00:04:30] to elect s that's become, by and large, the most common legal and tax setup for a small business. A successful small business is an LLC electing s, but LLCs only came into existence in the late 1970s early 1980s, and before that we had corporations. S corporations. Subchapter S of the Internal Revenue [00:05:00] Code was added, uh, in 1958. So we did have a couple decades there where we had s corporations but didn't have LLCs yet. And so those S corporations started off as state law corporations. So it's entirely possible to register a state law corporation or an LLC and elect S for that. There might be some other entity types, depending on your state corporation or Inc and LLC are the most common. [00:05:30]
Jeremy Wells: It depends on your state law, and it depends on what other kinds of entities are available. Now the entity itself can have no more than 100 shareholders. That number has actually gone up over the years. So when Congress passed the Technical Amendments Act of 1958, which created subchapter S, added that entire subchapter to the Internal Revenue Code, thus creating the S [00:06:00] Corporation. The limit was actually just ten shareholders. Again, the idea here of an S corporation is that it's for small businesses. There has historically been this sense that C corporations are big companies and S corporations are smaller companies. The idea here, with the introduction of subchapter S, was to get some of the benefits of incorporating some of the tax benefits of incorporating and make those available to smaller [00:06:30] businesses that didn't want all of the administrative burden of incorporation. The idea was that these were going to be relatively small businesses. And so originally the limit on the number of shareholders was just ten. Then the subchapter S Revision Act of 1982 phased in an increase in the limit to 25 shareholders for 1982 and then 35 shareholders the next year, 1983, [00:07:00] and then up to 50 shareholders in 1984. It stayed at 50 shareholders until 1996, when the Small Business Job Protection Act increased it to 75 shareholders. Starting in 1997, and then the American Jobs Creation Act of 2004 increased the limit to 100 shareholders effective 2005.
Jeremy Wells: And that's what it's been. So for a little over two decades now. We've had [00:07:30] s corporations limited to 100 shareholders, although historically that number has been smaller than that. I have never worked with an S corporation with more than a handful of shareholders. By and large, the overwhelming majority of S corporations have one, two, maybe three shareholders, there are going to be larger s corporations though some historical, some for various reasons because it might be a partnership electing s, although that [00:08:00] can turn into a relatively complex situation that I'll talk about later on in the episode, when we start getting into whether a business should be considered being an S corporation or not. But the limit here is 100 shareholders. Now, a shareholder is defined as an individual or spouses, family members and their estates. Those would all count as a single shareholder. So it's entirely possible [00:08:30] to have more than 100 individuals involved as owners, as long as some of those were spouses or close family members. And then for purposes of counting the number of shareholders in the S Corporation, those would count as just a single shareholder. So that's a way to get more shareholders into a closely held corporation. And [00:09:00] for various reasons that might be advantageous to the business. Although again, I've never worked with an S corporation that even came close to that 100 limit. Whether we counted, uh, spouses separately or not. None of the shareholders, though, can be, uh, anything other than an individual, a an actual human being other than certain permitted estates, trusts and organizations. [00:09:30]
Jeremy Wells: And there are very specific rules about what kinds of non individual shareholders there can be. And that's going to be way beyond the scope of this episode. Again, I've never worked in a situation where we had some sort of entity trying to be a shareholder in an S corporation. But what commonly can happen is a shareholder, uh, can, uh, include his or her interest [00:10:00] in an S corporation in his or her estate or even put that into a trust. And when that shareholder passes away now the estate or the trust steps into the place of that individual shareholder. This can actually be a really, uh, complicating situation for the S Corporation. There are there's a serious risk of, uh, inadvertently terminating [00:10:30] the selection when this happens. I strongly recommend talking to an experienced tax advisor, uh, who is familiar with s corporations and especially, uh, how to include an interest in s corporation in an estate plan, because that can very easily turn into an inadvertent termination. There are lots of tax court cases and even some district court cases that deal with the fallout of [00:11:00] a trust, or especially in a state, uh, stepping into the place of a deceased, uh, s corporation shareholder that can create serious problems for the S Corporation. The, uh, no shareholder can be a nonresident alien. Basically, that means that the shareholder, if it's an individual, typically needs to have a Social Security number.
Jeremy Wells: Uh, [00:11:30] that's basically the way I see that rule. Um, sort of paraphrased, really. That's not technically the rule. The rule is that a nonresident alien cannot be a shareholder in an S Corporation. One of the most important rules for S corporations is that it cannot have more than one class of stock. And the way the courts have defined a class of stock, based on what the code and the regulations [00:12:00] say, is that a separate class of stock exists when certain shareholders have differential rights to distributions. What does not count as a separate class of stock is differences in voting rights. So an S corporation can have voting and non-voting shares. What it can't have is common and preferred stock or have [00:12:30] situations like partnerships often do, where some investors, some shareholders have rights to distributions ahead of other shareholders. Sometimes this gets called waterfalls and partnerships. There are a lot of different ways that this can be structured for partnerships, and they're perfectly fine. They're perfectly legitimate for partnerships. However, for an S corporation, every single shareholder has to have an equal [00:13:00] right to distributions relative to the number of shares that they own. So if I'm a if I'm a shareholder in an S corporation and I own 10% of the stock in that corporation, then I always have a right to 10% of any of the distributions that come out of that's corporation. And there can't be any more complicated way of structuring that.
Jeremy Wells: If there is, then that's selection is essentially inadvertently [00:13:30] blown. And that's also been an issue that's been litigated in the tax court and even in district courts, resolving these situations where businesses elected. S Corporation treatment. But the way the rules for distributions were set up did not take that no second class of stock rule into account, and actually created a situation where the business had to choose between following its own rules as far as its [00:14:00] governing documents or following tax law. And in those cases, that selection usually loses and is inadvertently terminated for the corporation. And then finally, uh, the entity can't be an ineligible corporation. That essentially means a corporation, which is a financial institution which uses the reserve method of accounting for bad debts, described in section 585 of the Internal Revenue [00:14:30] Code. An insurance company subject to tax under subchapter L of the Internal Revenue Code, or a domestic international sales corporation or Disc. Any business that is one of those three kinds can be an S corporation. I don't have any clients that fit those criteria. So generally the businesses that I've worked with are typically domestic corporations or other kind of domestic eligible entity. All of the shareholders meet the shareholder [00:15:00] criteria for an S corporation. Generally, it's not a problem under IRC section 1361 for a for an eligible entity that wants to elect s and particularly talking about limited liability companies here, LLCs, something that is important to keep in mind and that I see, uh, misunderstood quite a bit still even, is that there is no need for [00:15:30] a separate corporate election.
Jeremy Wells: So an eligible entity that makes a timely selection is treated as having made an election to be classified as an association, and that's the term used in what's known as the check the box regulations. Those are in the Treasury Regulations section 301.7701. And they're one, two and three. And those collectively are known as the check the box regulations. [00:16:00] And they're all about the different kinds of entities for tax purposes, and how those different kinds of entities can choose to be other kinds of tax entities in those regulations. The it's written that the eligible entity does not have to file a separate election if it wants to be an S corporation. When it makes the selection. It also makes the election to be [00:16:30] classified as an association, and then instantaneously makes the election for that Association to be treated as an S corporation. The default for an association is to be a C corporation. So essentially with that selection, what that eligible entity is doing is making two instantaneous selections. First, it's electing to be treated as an association which makes it by default a C corporation. Then it's also electing S corporation treatment. Now [00:17:00] this is important to keep in mind not when making the election because it just makes one election to become an S corporation.
Jeremy Wells: But it's important to understand that two step process occurs because if that corporation wants to no longer be an S corporation, then if it's an LLC, if it's a limited liability company electing S, then it made the election to be an association. So if [00:17:30] it wants to revert back to being either a disregarded entity as a single member LLC or partnership as a multi member LLC, then it has to file form 8832 Entity Classification Election. In order to revert back from being a C corporation to being its default entity type. Check out episode 15 of this podcast, Breaking Up with your S Corp part two, which is where I talk about, uh, this. [00:18:00] So go listen to that episode after you finish this one. If what I just said isn't clicking or doesn't make sense. Now, an LLC, which is treated as a disregarded entity or partnership by default, does not file form 8832 entity classification election when it makes the selection. That's the point of the check the box regulations when it comes to making an selection. If there is no need to separately file form 8832. First, I still see practitioners [00:18:30] tax professionals thinking they need to file both. That will just confuse the situation. That will make a mess of the situation. Do not file form 8832 to elect a C corporation first, and then file the 2553. Just file the 2553 to elect s the only time with an S corporation where you would need to file form 8832 is if that's corporation had revoked [00:19:00] or otherwise terminated its selection, and then wanted to get back to its default treatment as either a disregarded entity, a sole proprietorship, or as a partnership under the Check the Box regulations.
Jeremy Wells: The S selection includes both the election to be classified as an association, and then to be treated as an S corporation. That all comes from Treasury Regulation section 301.77013 [00:19:30] and then C15C. So it's it's buried a little bit into the structure of that particular regulation. But it's there now that deemed entity classification election. In other words that selection that includes within it that election to be treated as an association applies as of the effective date of the s Corporation election, and it remains in effect until the [00:20:00] entity makes a valid election to be classified as something other than an association. So it's important to keep that in mind that even though there is no separate corporate election made for an LLC electing to be an S corporation, that election was deemed to be made. It was just implicit in making that selection. So there's no need to file a separate 8832 you only file form 2553. The due date [00:20:30] for an s election to be effective. Current effective in the current taxable year is the 15th day of the third month of that year. Generally, we say March 15th for a calendar year taxpayer. If that entity wants to be an S corporation for the current tax year, then it needs to file that election by March 15th of the current year.
Jeremy Wells: An election made during [00:21:00] the current year, but after the 15th day of the third month of the year, is treated as if it made it for the following tax year. So if that entity doesn't get the election in by March 15th for a calendar year taxpayer, then it's going to be treated as if it made that election for the following year. So, for example, for a calendar year taxpayer an election effective as of January 1st, 2026 [00:21:30] has to be filed by March 15th, 2026. If the elections filed after that, then it's treated as if it was made for 2027. It will go into effect on January 1st, 2027. It's important to keep that due date in mind in a little bit. I'll talk about ways that we can get around making that election. If you missed the original due date for that election, we'll talk about how to make a late [00:22:00] selection. Now, the election is going to be made with form 2553. I've already mentioned that a few times. That is the form to make the selection. The eligible entity makes the election by either mailing the original or faxing that original form. 2553 election by a small business corporation to its designated IRS service center that's going to be either the Kansas [00:22:30] City, Missouri, or the Ogden, Utah Service Center. And in the instructions for form 2553, there is a table that shows two groups of states.
Jeremy Wells: And if the eligible entity is in a state that should send its election to Kansas City or to Ogden, then that table will show you and it'll give you the contact information for those two service centers. So you got to look at the instructions and you got to know what state [00:23:00] that's corporation primarily operates out of. And that will tell you which service center to send the election to. So how do we prepare form 2553. The first part includes information about the electing entity, the name and the address of the entity, which is going to be important because the IRS is going to respond to that election with either an approval [00:23:30] letter or with a letter indicating why there was a problem with the election and the IRS couldn't process it. And it's going to send that to the entity at the address on that election form. So you want to make sure that is current and up to date, and is going to be an address that the officers or the shareholders of this s corporation are going to be checking frequently. You're also going to have the employer identification number, the Ein for the entity. It is absolutely [00:24:00] critical to understand that electing S for an entity does not require a new Ein. That said, if a new entity is created just to be able to elect S for an existing business, then the new entity needs to get an Ein first.
Jeremy Wells: So let me walk you through a situation that we've dealt with in my firm over [00:24:30] the last couple years here. We had sole proprietorships that had no state level entities registered. They had eyes for payroll purposes, but they were sole proprietorships, so they were filed on form schedule. They were filed on schedule C, part of the sole proprietors form 1040 personal tax return. And they used their own Social Security number as the tax ID for [00:25:00] that activity because there was no separate entity. The aim was purely for payroll purposes. When those sole proprietorships decided they wanted to elect S, there had to be some entity registered in order to elect S, there was no eligible entity. You can't register. You can't elect S if there is no entity in existence. So these sole proprietors, registered LLCs, tried [00:25:30] to use the same Ein that they had as sole proprietors to make the selection. The problem is, the IRS will reply to that election with an acceptance letter, but with a caveat. Irs will assign a new AI to that new entity because the sole proprietors can't be used for a new entity. So if you're going to, uh, [00:26:00] advise a taxpayer to elect s, but that taxpayer does not currently have a legal entity registered, then it's absolutely critical that you understand that that new entity that's going to elect S has to get a new Ein, even if the owner, the sole proprietor, already has an ein that Ain was for payroll purposes strictly for that prior activity.
Jeremy Wells: It does not carry over [00:26:30] to the new entity. It cannot be used for the selection. What will happen is IRS will assign the new Ein. And then if you choose to file those 1120 S's under the old sole proprietors ein. After a couple years of that, IRS will send a notice to the S Corporation saying that it has unfilled 1120 S's because no 1120 S's were filed under the Ein that the [00:27:00] IRS correctly assigned to that's corporation. So just make sure that if a new entity is required to be registered in order to elect S, that you get a new Ein for that entity and use that for the selection. You're also going to put the date and state of incorporation for the entity now on the form, it says date and state of incorporation. When we're talking about a limited liability company. [00:27:30] The rules are different for states. Llcs aren't incorporated. They're not corporations. However, we use the same date as the date that that LLC was registered. So whatever the dates on the articles of organization are for that, LLC is what we use for the date of incorporation. Now, that might be a different date than the effective date of the selection, or it [00:28:00] could be the same date if the entity is registered and wants to be an S corporation as of the date that it was registered in that first year.
Jeremy Wells: What you can't have is an S effective date, an S election effective date that is before the date of incorporation of that entity. I have seen 2553 where the entity was registered somewhere in the middle of the year, and [00:28:30] the effective date was the 1st of January. That doesn't make sense. You can't elect s Big Four the entity actually exists. So the earliest that effective date can be is that incorporation date. So that's one reason it's important to keep that in mind when you are preparing form 2553. And again, just to reiterate this point, there is no new AI. When [00:29:00] an existing entity elects s, an entity retains its Ein when it makes a tax entity type election. That comes from Treasury Regulation section 301.6109 1H1. No new Ein for an election. That is a situation that will also create a lot of confusion between the corporation and or the entity and the IRS. [00:29:30] Part one also includes information about the election itself. So I've already mentioned this, but the effective date of the election and what I just said about the effective date versus the date of incorporation is actually stated there in there is a caution, uh, next to that effective date that says, quote, a corporation or entity making the election for its first tax year in existence will usually enter the beginning date of a [00:30:00] short tax year that begins on a date other than January 1st. Apparently, so many people made this mistake electing s that IRS felt the need to print this on the form itself.
Jeremy Wells: So if the registration date or the incorporation date for the entity is after January 1st. Then don't put January 1st as the effective date. Later on, I'll talk about whether an entity should elect S in its first calendar year of existence. [00:30:30] I generally think that's a bad idea, unless that business has already been in existence without a registered entity. But I have seen a lot of situations where, uh, individuals, entrepreneurs, they're talking about a business idea. So they go register an LLC and they immediately want to elect s. I generally discourage that. I think that's a bad idea. We need to do some analysis, make sure that the entity is right for electing s, but if it should, then it's important to note that it can't make that election [00:31:00] effective on a date before the entity actually exists. Also, if electing S corporation wants to adopt a tax year other than a calendar year, and this is also in form 2553, there are four options. One of them is calendar year, which to me is the default. Um, it's not technically the default, but to me, uh, that's generally what we are choosing is a calendar year tax year. However, if the corporation if the S corporation [00:31:30] wants something other than a calendar year tax year, then it makes that election on form 2553. It does not separately file form 1128 application to adopt, change or retain a tax year if it's choosing to make a different tax year.
Jeremy Wells: With the selection. Now if it elects s and chooses calendar year and then wants to change that later on, that's when it would file form 1128. Also, and this is important, the name, title [00:32:00] and telephone number of an officer or legal representative that the IRS can call for more information. Again, if there's an issue with the election, then IRS might try to contact this individual. So it's important to have somebody who is trusted who is capable of talking to the IRS, and that that contact information is up to date. There's also an explanation of the reasons the election wasn't made on time, and a description of diligent actions to correct the mistake upon its discovery. I'm going to cover this [00:32:30] more later on. And then finally, there is the signature title and date of the officer who signs the following statement. Quote, under penalties of perjury. And keep that in mind. I declare that I've examined this election, including accompanying documents and to the best of my knowledge and belief, the election contains all the relevant facts relating to the election, and such facts are true, correct and complete. This is an important point to consider that [00:33:00] this form is taken seriously by the IRS, to the point at which whoever is signing off on this election says that everything on this form is true, correct and complete to the best of my knowledge, under penalties of perjury.
Jeremy Wells: That's going to be especially important when we talk about late elections here in a few minutes. That's all on page one. On page two is the name, address, tax ID number, [00:33:30] the number or percentage of shares in acquisition date and the tax year end for each individual shareholder. Now notice I said tax ID number and not Social security number. Because again there can be some entity types other than individuals that are eligible s corporation shareholders. Although in my particular practice that's rare. However it is possible. So there does need to be an accounting for that. And then finally the signature and date of shareholders consent. So for each [00:34:00] shareholder it's essentially a grid on page two where you have the information I just listed. And then each shareholder signs inside that grid in a column that has its as its header the following statement under penalties of perjury. Again, I declare that I consent to the election of the above named corporation or entity to be an S corporation under section 1362 A. And then I've examined this consent statement, including [00:34:30] accompanying documents. And to the best of my knowledge and belief, the election contains all the relevant facts relating to the election, and such facts are true, correct and complete. I understand my consent is binding and may not be withdrawn after the corporation or entity has made a valid election. If seeking relief for a late filed election, I also declare, under penalty of perjury that I have reported my income on all affected tax returns consistent with the S Corporation election for the year for which the election should have [00:35:00] been filed and for all subsequent years.
Jeremy Wells: So again, we have this under penalties of perjury, uh, statement included here. So now I've mentioned it a few times. Late election relief. What is this now saying that an s election has to be filed by the third, the 15th day of the third month, by March 15th for a calendar year taxpayer. A lot of businesses just don't know that early in the year whether they want to make that election [00:35:30] for the year or not. And so in subchapter S, uh, in fact, in section 1362, there is an allowance for uh, relief for late elections. So this is section 1362 B5. The Secretary of the Treasury may treat an s election as timely made for the taxable year if she determines that an electing entity has reasonable cause for failing to make a timely [00:36:00] election. Then, in Treasury Regulation section 301.9 thousand 101, the Commissioner of Internal Revenue can grant a reasonable extension of time to make a regulatory election or a statutory election under the IRC, except for certain subtitles and entity classification, election is a regulatory election. So in that regulation, the Secretary of the Treasury is essentially [00:36:30] delegating the ability to grant that relief for a late election to the Commissioner of Internal Revenue, the head of the Internal Revenue Service.
Jeremy Wells: And then in uh, Treasury Regulation Section 301,103, the Commissioner can grant relief for a late entity classification election, which is what an election is when the taxpayer provides evidence establishing to the satisfaction of the Commissioner or to the IRS [00:37:00] that the taxpayer acted reasonably and in good faith, and that the grant of relief will not prejudice the interests of the government. So this is the the statutory and then the administrative framework for how we think about late election relief for late s corporation elections. From that, we get over the last few decades a series of revenue [00:37:30] procedures. And these are documents issued by the Internal Revenue Service that essentially lay out procedures for these sort of special kinds of ways of reporting things to the IRS or asking the IRS to do things. And in particular, Rev Proc 20 1330 took a lot of these different revenue procedures that had to do with late entity elections and consolidated a lot of them into one. [00:38:00] And this is now the most current version of how an entity can request relief for a late s selection, along with a few other kinds of elections, including an Electing Small Business Trust or a qualified subchapter S trust. A SST, a qualified subchapter S subsidiary which is known as a Qsub. And then, of course, late corporate classification election. So all of that is handled in [00:38:30] red proc 20 1330. Now the IRS will grant relief for a late s corporation election if the requesting entity meets four general requirements.
Jeremy Wells: And it's absolutely critical if you're advising an entity to make a late selection, or if you're if you own an entity that wants to make this late selection, that you understand these four criteria. It intended to be classified as an S corporation as of [00:39:00] the effective date. To me, this one is probably the most important to really nail down that it intended to be classified as an S corporation. How do we show intent? There is some precedent, mostly in the form of PLR, which is ironic because they're not precedential, but private letter rulings that the IRS has issued when it comes to entity type elections. Typically look at a few criteria where [00:39:30] the IRS is trying to, uh, demonstrate or the entity is trying to demonstrate that it actually intended to be classified, even though it didn't get that election in until late. So a lot of times it's board meetings, uh, minutes. It's, uh, corporate resolutions, things that a lot of small business owners aren't doing. But in that case, you might look at communication with a tax advisor, uh, these sorts of things. Anything you can do essentially to prove that [00:40:00] the entity had intent to be classified even though it didn't get the paperwork in on time. The second criterion here is that it requests relief within three years and 75 days after the effective date. There's one exception to this that I'll talk about later, but you essentially have three years, one month, and 15 days after the effective date in order to get that late election relief requested.
Jeremy Wells: Three it fails [00:40:30] to qualify as an S corporation as of the effective date solely because it did not timely file the election. In other words, everything else is fine with this entity. It just didn't file the paperwork on time. And then four. It has reasonable cause for its failure to make the timely election, and has acted diligently to correct the mistake upon its discovery. A lot of times this is going to look like the ownership simply did not understand [00:41:00] the requirements to elect s. They wanted to they intended to. They didn't understand the paperwork that was necessary or the deadlines. That might be your case for reasonable cause. There are no strict criteria on what actually is reasonable cause here. I've seen a wide variety of, uh, suggested language for the reasonable cause component. Uh, some of them, uh, successful. Right. Uh, and so [00:41:30] it really depends on how you structure that. Uh, the most common one that I see is that the, uh, entity and its ownership, they just simply didn't understand this stuff is complicated, and they didn't understand the paperwork involved until they were advised by a tax professional. This is all section 4.02 of proc 20 1330 where these four requirements come from. Now, in order to get rate late relief, you still use [00:42:00] form 2553 to make that selection, but the rep proc says to make a couple of adjustments here.
Jeremy Wells: So first of all, at the top of the front page of form 2553 and all caps print at the top, filed pursuant to Proc 20 1330. That is a signal that's a big flag to whoever's processing that particular form, that this is a request for relief for a late s [00:42:30] election. If you're using software, tech software to prepare this, usually there's a checkbox in the software under that 2553 section or page that will go ahead and print that statement at the top of it for you. We use that in our firm. Also. The form has to include a reasonable cause statement that I just described that is explaining the failure to timely file the election and [00:43:00] the entity's diligent actions to correct the mistake upon its recovery. And that's really if you look at form 2553, page one, the bottom half, uh, is essentially a lot of blank lines. Uh, it's like an old school essay section, uh, of a worksheet from from school or college. Uh, and that is essentially where you fill in this reasonable cause statement or what I've also seen, if there's some more explanation [00:43:30] that's needed, is you can just put see attached and then attach on a separate sheet of paper the actual reasonable cause statement. It just depends on how long that reasonable cause statement or you know, how the formatting makes it look.
Jeremy Wells: We use, uh, tax software a lot of times to prepare uh, forms 2553. And so a lot of times we'll just type that directly into the tax software, and it will print it and make it look, uh, pretty decent. That's from section 4.031 of the red proc 20 1330. Now, [00:44:00] if the S Corporation has filed all forms 1120 s for tax years between the effective date and the current year, then you attach the completed form 2553 to the current year form 1120 S as long as the current year form 1120 S is filed within three years and 75 days of the effective date. That is, in the red proc section. 4.0 32A. I have seen mixed, uh, feelings [00:44:30] on this because I've seen some practitioners say anything that you attach to an e file. Uh, Iris is probably never going to see that because everything just kind of goes into the computer. Uh, at least the data, uh, does. Nobody's looking at the actual forms. However, the red proc specifically says to attach that, uh, form 2553 to the return. What we generally do in our firm is we fax that in to the service center, and [00:45:00] we attach a PDF of that file to the return. Can't can't hurt to do it both ways, at least in our experience, we find that it does actually get processed doing both. I'm not sure which one works or if they don't both work, but that's generally what we do in our firm.
Jeremy Wells: Now note that, uh, filing form 7004, a request for an extension for form 1120 S does not extend [00:45:30] the due date for the actual election itself. There is no way to extend the filing of form 2553 of the actual election. All you can do is request relief for a late filed election, but that still can't go beyond three years and 75 days. If the S Corporation has not filed forms 11/22. Then you attach the completed form 2553 to the current 1120 [00:46:00] S, as long as the current one is filled within three years and 75 days, and then simultaneously file all the delinquent forms 1120 S. We've done this before where we need to catch up for a couple of years for an 1120 S, and we just file them all together. It's a little bit dicey. I don't feel good doing that. I don't like filing that many returns on top of one another, but I've done it before, and, uh, it it works. Um, or it can work. [00:46:30] And then if the requesting entity can file the form 2553 directly with the applicable, uh, service center, then just go ahead and do that. Generally, that's what, uh, we do along with attaching it to the return. Now I'm going to come back to this to reemphasize it. The required reasonable cause statement that needs to be included on form 2553 pursuant to Reb. Proc 20 1330 has [00:47:00] to contain a dated declaration signed by an officer of the S Corporation that states under penalties of perjury, I declare that I have examined the selection, including accompanying documents, to the best of my knowledge and belief.
Jeremy Wells: The election contains all the relevant facts relating to the election, and such facts are true, correct and complete. So that goes along with that, uh, signature under penalties of perjury on form 2553 uh itself. That [00:47:30] election also has to include shareholder statements. Now that's all hard coded into page two, the grid on page two of form 2553. So if the uh shareholder signed that, then that essentially covers that shareholder statement. One thing that is annoying, but has be kept in mind with form 2553 is all of the signatures that I've mentioned. They still have to be wet ink signature. There is no way to get e-signatures [00:48:00] on a form 2553 to get that approved. Now, I'm sure somebody listening to this is going to say, well, I just make it look like it's been or I've submitted E-sign 2553 and they've been accepted. I'm sure you've gotten that through somehow. There is no way to file correctly a 2553 with E-signatures. It has to be wet ink signatures. It's annoying. In our firm. What we do [00:48:30] is we provide a copy through our secure portal. The we tell the taxpayer you're going to have to print, sign and scan this and get it back to us. And our portal software includes a scanner in the smartphone application that it uses.
Jeremy Wells: And so we try to walk them through that process. It's annoying but that's just how it has to go. Uh, if the IRS does not respond promptly to [00:49:00] the request for, uh, relief, then that can provide extra time. So the three year and 75 day limit does not apply. If the following is true, that the requesting entity and all of its shareholders reported their income consistent with s corporation status for the year, the S Corporation election should have been made and for every subsequent taxable year, if any, that at least six months have elapsed since the date [00:49:30] on which the corporation filed its tax return. For the first year, the corporation intended to be an S corporation, and neither the corporation nor any of its shareholders was notified by the IRS of any problem regarding the S Corporation status within six months of the date on which the initial form 1120 was timely filed. That's in red. Proc 20 1330. Section 5.04. That's the one exception to the three year and 75 day limit. Essentially, if the IRS [00:50:00] just fails to notify the entity or any of its shareholders. So always make sure if you're advising taxpayers that are electing s, always make sure that they understand they need to be checking their mailboxes regularly, because IRS will correspond only via mail in response to an selection. If the requesting entity doesn't satisfy the requirements of Proc 20 1330, then [00:50:30] it can request a private letter ruling a PLR from the IRS seeking relief for a late election.
Jeremy Wells: Polls can get kind of expensive though. Um, but if the entity doesn't satisfy the requirements of that proc, that's really the only option left. Now quickly, if you haven't listened to episode three S Corporation Reality Check, I strongly recommend listening to that episode. But I want to cover some points here on when [00:51:00] to advise an selection and how to make that recommendation. Uh, in that episode, episode three, I talk about some common red flag issues that I see that make me pause before recommending an selection. So I want to try to take a little bit of a positive spin, but I'm going to reference some of the things that I discussed in that episode. So once you finish this episode, I definitely recommend going and listening to that one as well. First of all, don't rely on rules of thumb. The typical purpose of an S [00:51:30] corporation is to eliminate an owner's self-employment tax burden and replace it with what should be a smaller payroll tax burden. So this leaves a lot of practitioners to rely on an overly simplistic rule of thumb, Usually the way that gets discussed is if you make more than a certain amount and it's usually some middle five figure amount, then that business should elect s. Those rules of thumbs can be very dangerous, because they often [00:52:00] omit a lot of the nuance that I'm going to talk about here in a minute.
Jeremy Wells: The first thing you have to do when you're considering whether an entity should elect S is review the ownership structure. S corporations don't have the same flexibility that partnerships do when it comes to tax treatment of owners, such as special allocations and differential rights to distributions. So you have to confirm the entity's ownership can actually live with the rules of subchapter [00:52:30] S, not subchapter K. Now, I taught a two hour webinar last year for the New York State Society of Enrolled Agents on how to review LLC operating agreements for Non-attorneys. That is something that I would strongly recommend you look into if you're advising owners on making selections, if you're not already requesting copies of operating agreements for those LLCs, I strongly recommend doing that, and I strongly recommend always looking at the operating agreement [00:53:00] before you recommend an selection. Operating agreements are usually written from the perspective of subchapter K, not subchapter S, and that can cause pretty significant problems. There's going to be a lot of partnership language in those operating agreements. And it's not going to translate well for an S corporation. So you need to actually look at that operating agreement and make sure that it accounts for an selection, and that it's not setting up the owners to make decisions or have [00:53:30] to do things that's going to inadvertently blow or terminate that selection. You've also got to review the balance sheet. Always examine the entity's balance sheet before recommending an selection.
Jeremy Wells: So unlike partnerships, S Corporation shareholders don't get basis for corporate debt. They can have debt basis for bona fide shareholder loans to the corporation. But personal guarantees don't count. There is no recourse versus non recourse [00:54:00] debt considerations in an S corporation the way there might be in a partnership. Also transferring liabilities in excess of assets into the S Corporation as part of the section 351 exchange. That happens when that entity makes that deemed corporate election can trigger a taxable event. I have a post on my website, J dot tax that's all about accounting for an S selection. And it walks through that corporate transfer and [00:54:30] that exchange that happens under section 351. And it's important to understand that happens with an S election. You can't just move the balance sheet from the sole proprietorship or partnership onto the S Corporation schedule L, you actually have to do the corporate transfer. That usually looks like a journal entry in the books. And if you're not careful and if the balance sheet isn't, uh, the way it needs to be, that can trigger a taxable event. [00:55:00] Also, appreciating fixed assets such as real estate can cause significant issues due to built in gains, and there is no section 754 inside basis. Step up because again this is a corporation not a partnership. And then finally don't ignore non self-employment tax implications. The one factor that gets focused on with S corporations that I mentioned earlier is of course self-employment tax.
Jeremy Wells: And yes generally [00:55:30] s corporations reduce the self-employment tax burden by switching it out for less payroll tax. However, what can also happen is with wages paid by an S corporation to its owners that is deductible for the business and that reduces its qualified business income. That, in turn will reduce its section 199 cap a qualified business income deduction. [00:56:00] I've seen a lot of cases where the reduction in QBD offsets some even most of the self-employment tax savings to where essentially it's a wash and you have to look at state and local taxes as well. Several states and localities impose taxes on S corporations. Now s corporation might be a pass through entity for federal tax purposes, but [00:56:30] in some states and localities they are separately taxed. New York City has a general corporation tax of 8.85% that can completely wipe out any tax savings from an S corporation. New Hampshire has a business profits tax of 7.5%. Tennessee has a franchise and excise tax of 6.5%. And then, of course, California has its famous franchise tax of 1.5%. And Illinois has a new [00:57:00] personal property replacement tax of 1.5%. Now, 1.5% for California or Illinois, there's usually still plenty of s corporation tax savings if the S Corporation is profitable enough. But Tennessee, and especially New York City, essentially wipe out any possible tax savings for an S corporation makes them very rarely, uh, viable options in those places. So to wrap up, make the selection when [00:57:30] the business is consistently profitable enough to support reasonable wages and all of the administrative burden of an S corporation.
Jeremy Wells: If it can't handle that, if the ownership can't handle that, then it's not a viable solution for that business. There's also going to be a higher compliance cost. It's going to be more expensive just in general to operate an S corporation than another simpler entity type. And [00:58:00] then don't forget to take qualified business income deduction and state and local taxes on s corporations into account when you're looking at whether to make that selection. And finally, make sure the ownership structure, including the legal structure, the equity structure and especially the exit structure, what are the owner's exit plans? How are they going to get out of this corporation? All of the rules for that can be significantly [00:58:30] different under an S corporation than under a sole proprietorship or a partnership. Final point here. Don't rush into an election. Yes, late elections are possible. Yes, the self-employment tax savings might be lucrative, especially when you're preparing last year's schedule C for a client and seeing how much the self-employment tax burden is. But unless the entity has the capability to operate as an S corporation, and it [00:59:00] actually had the intent to do so throughout that year, then don't rush with that's selection. Make the recommendation for the current year, not the prior year. That's general standing recommendation there. So if you found value in this episode, please let me know by liking and leaving a comment in your podcast application of choice or on YouTube. Thank you for listening as always.