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Eligibility and Election
S - CORPORATIONS
For an LLC, Partnership or a Corporation to be treated as an S corporation, it must meet specific eligibility requirements, and the necessary election must be in effect. An S corporation, often referred to as a Subchapter S corporation, follows a set of rules related to its structure, shareholders, and operations.
When considering whether to elect S Corporation status, it's important to understand that this is a federal election. Before reaching this stage, you'll need to first register your business at the state level, deciding whether to operate as an LLC or a C Corporation. Once your business has demonstrated its ability to generate income and pay reasonable compensation to its shareholders, you can apply for S Corporation election.
A critical aspect to keep in mind is payroll. Even after electing S Corporation status, some states may still classify you as self-employed for payroll tax purposes. This means you could be exempt from certain payroll taxes, although workers' compensation is generally an exception and may still apply depending on your state. It's important to consider these factors as you decide whether S Corporation status aligns with your business goals.
Eligibility Requirements
Single Class of Stock:
An S corporation can only have one class of stock, meaning all shares must have identical rights to profits and assets. However, differences in voting rights are allowed. Issuing debt doesn’t disqualify an S corporation unless the debt gives the holder control over the corporation, which could be considered a second class of stock.
Shareholder Limits:
The number of shareholders is limited to 100. A married couple counts as a single shareholder, and family members within a six-generation range are also treated as a single shareholder.
Domestic Corporation:
The corporation must be domestic and eligible under U.S. law. Accumulating earnings and profits (E&P) doesn’t prevent a C corporation from electing S corporation status.
Shareholder Eligibility:
Nonresident aliens (NRAs) can’t own shares, but resident aliens can. Eligible shareholders include individuals (including single-member LLC owners), estates, and certain trusts. Trusts that qualify include those fully owned by a U.S. citizen or resident, trusts created under a will, voting trusts, and electing small business trusts. Charitable Remainder Trusts are not eligible.
Ineligible Entities:
Some entities, such as certain insurance companies, possession corporations, and domestic international sales corporations (DISCs), cannot elect S corporation status. However, some mutual savings banks and cooperative banks can.
Subsidiary Ownership:
An S corporation can own C corporations or Qualified Subchapter S Subsidiaries (QSSS), which are 100% owned by the S corporation parent and included in the parent’s tax return.
Election Process
To elect S corporation status, an eligible corporation must file an election (Sec. 1362). All shareholders at the time of the election must consent by signing Form 2553, "Election by a Small Business Corporation." If shareholders who owned stock earlier in the tax year don’t consent, the election is deferred to the following year.
Timing of Election:
If the election is filed within the first 2.5 months of the corporation’s tax year, it is effective from the first day of that tax year. If filed later, it becomes effective on the first day of the following tax year.
Late Election:
The IRS can accept a late-filed election if reasonable cause for the delay is determined.
Revocation and Termination:
An S corporation election can be terminated if certain conditions aren’t met. For example, the election is automatically terminated if more than 50% of shareholders vote to revoke it. The IRS can waive termination if the issue is resolved within a reasonable time.
Special Circumstances
Passive Investment Income (PII) Termination:
If a corporation has Subchapter C E&P and PII exceeding 25% of gross receipts for three consecutive years, the S election may be terminated at the beginning of the fourth tax year.
Transfers to Ineligible Shareholders:
Transferring shares to ineligible shareholders (e.g., nonresident aliens) can terminate the S corporation status. However, the IRS may grant a waiver if the transfer was inadvertent.
Example:
If a shareholder passes away, their estate temporarily holds the shares. If the estate transfers the shares to an ineligible party, such as a nonresident alien, the S corporation status could be terminated unless the IRS grants a waiver.
Accounting Method and Tax Year
Accounting Method:
An S corporation isn’t required to use the accrual method unless inventory sales are a significant part of operations. The S corporation typically elects its accounting method, but shareholders may make certain elections themselves, like choosing how to handle foreign income taxes.
Tax Year:
An S corporation usually adopts a calendar tax year. It may adopt a fiscal year with IRS consent if it can show a valid business purpose. For example, a ski resort might choose a fiscal year ending after the peak snow season. A fiscal year can also be elected under Sec. 444, which requires a deposit to offset the tax deferral.
Example:
If an S corporation wants to retain its existing October 31 year-end for consistency, it may do so by making a Sec. 444 election, provided it makes a noninterest-bearing deposit with the IRS.
Administration
The tax treatment of an S corporation’s income, loss, deductions, and credits is determined at the corporate level, and each shareholder’s pro rata share of these items is reported on their personal tax return.
Example:
If an S corporation has two shareholders with different tax years, each will report their share of income according to their tax year-end.
Filing Requirements
An S corporation’s income tax return (Form 1120S) is due by the 15th day of the third month following the close of its tax year (e.g., March 15 for calendar-year taxpayers). An automatic six-month extension is available by filing Form 7004.
What do you mean by adjusted basis and stock in S - Corporations?
In the context of S corporations, understanding adjusted basis and stock is crucial for accurate tax reporting and determining gains or losses on distributions or sales of stock. Here’s what each term means:
Adjusted Basis
Adjusted basis refers to the taxpayer’s investment in the S corporation stock, adjusted for various factors over time. It represents the amount of investment that has been made in the stock and can be used to calculate gain or loss when the stock is sold or when distributions are made. The basis is adjusted as follows:
Initial Basis: The initial basis in the S corporation stock is usually the amount paid for the stock when it was acquired.
Adjustments to Basis:
Increase Basis: Basis is increased by additional capital contributions made to the corporation and by the shareholder’s share of the corporation’s income (both ordinary and capital gains).
Decrease Basis: Basis is decreased by any distributions received from the corporation (to the extent they do not exceed the basis) and by the shareholder’s share of the corporation’s losses and deductions.
Effect of Distributions: If distributions exceed the shareholder’s adjusted basis, the excess amount is treated as a capital gain.
Stock in S Corporations
Stock in the context of S corporations represents ownership interests in the company.
Here’s how it works:
Ownership and Basis: Shareholders own stock in the S corporation, and their adjusted basis in this stock reflects their investment in the corporation. This basis is important for tax purposes, especially when receiving distributions or selling stock.
Distributions: When an S corporation makes distributions to its shareholders, these distributions can affect the adjusted basis of the stock. Distributions are generally tax-free to the extent of the shareholder’s adjusted basis in the stock. Any distribution beyond the adjusted basis is treated as capital gain.
Pass-Through Income and Losses: S corporations do not pay federal income tax at the corporate level. Instead, they pass through income, deductions, and credits to shareholders. The shareholders report this pass-through income or loss on their personal tax returns, and it affects their adjusted basis in the stock.
Example: Adjusted Basis and Stock in an S Corporation
Scenario:
Emily owns 100% of the stock in Maple Corporation, which is an S corporation. At the beginning of the year, Emily’s adjusted basis in her Maple Corporation stock is $15,000. Throughout the year, Maple Corporation reports $8,000 of ordinary income. In November, Emily receives a cash distribution of $25,000 from the corporation.
Adjusted Basis Calculation:
Initial Basis:
Emily’s initial basis in her stock at the start of the year is $15,000.
Adjustments to Basis:
Increase Basis:
Emily’s basis is increased by her share of the S corporation’s income. In this case, Maple Corporation reported $8,000 of ordinary income. Thus, Emily’s basis increases by $8,000.
New Basis: $15,000 (initial basis) + $8,000 (income) = $23,000
Decrease Basis:
Emily receives a cash distribution of $25,000 from Maple Corporation. Distributions are generally tax-free to the extent of the adjusted basis. Since Emily’s adjusted basis before the distribution was $23,000, this basis will be reduced by the amount of the distribution.
Adjusted Basis After Distribution: $23,000 (adjusted basis) - $25,000 (distribution) = -$2,000
Since the distribution exceeds the adjusted basis, the excess amount is treated as a capital gain.
Effect of Distribution:
The distribution amount exceeds Emily’s adjusted basis by $2,000 ($25,000 - $23,000). Therefore, Emily recognizes a $2,000 capital gain.
Summary:
Initial Basis: $15,000
Increase due to Income: +$8,000
Adjusted Basis Before Distribution: $23,000
Distribution Received: $25,000
Excess of Distribution over Basis: $2,000 (treated as capital gain)
Tax Implications:
Emily’s $2,000 capital gain will be reported on her personal tax return.
The remaining basis after the distribution becomes negative, but for tax purposes, it is adjusted to zero.
Understanding these adjustments helps shareholders accurately determine their tax liabilities and manage their investments in S corporations.
How to establish a stock for S- Corporations?
Establishing and managing stock for an S corporation involves several key steps, starting from the creation of the corporation to issuing shares and maintaining proper records. Here’s a comprehensive guide on how to establish and handle stock for an S corporation:
1. Forming the S - Corporation
Incorporate the Business:
Choose a State: Incorporate in the state where you intend to do business.
File Articles of Incorporation: Submit the necessary documents to the state’s business registry (often the Secretary of State’s office). This includes providing basic information about the corporation, such as its name, address, and purpose.
Create Corporate Bylaws:
Draft bylaws that outline how the corporation will be governed, including the rules for issuing stock, holding meetings, and other corporate procedures.
Obtain an Employer Identification Number (EIN):
Apply for an EIN from the IRS. This number is used for tax reporting purposes.
Elect S Corporation Status:
File IRS Form 2553, "Election by a Small Business Corporation," to elect S corporation status. This form must be filed within a specific time frame, generally by the 15th day of the 3rd month of the tax year for which the election is to be effective.
2. Issue Stock
Determine Stock Structure:
Decide on the type and number of shares to be issued. S corporations typically issue common stock, and the number of shares is defined in the Articles of Incorporation.
Set Stock Par Value:
The par value of stock is the nominal value assigned to each share. It can be a very small amount or even a nominal value like $0.01 per share. This value is specified in the Articles of Incorporation.
Issue Stock Certificates:
Issue stock certificates to shareholders as evidence of ownership. Although some states and companies now use electronic records, physical certificates may still be used. Each certificate should list the shareholder's name, the number of shares, and the class of stock.
Maintain Stock Ledger:
Keep a stock ledger to record the issuance and transfer of shares. This ledger should include:
Shareholder names
Number of shares held
Dates of issuance or transfers
Any stock certificates issued
3. Manage Stock and Record Keeping
Regular Updates:
Update the stock ledger whenever shares are issued, transferred, or redeemed. Ensure all records are accurate and up-to-date.
Hold Annual Meetings:
Conduct annual shareholder meetings as required by state law and corporate bylaws. Document these meetings in meeting minutes.
Comply with Reporting Requirements:
Adhere to state and federal reporting requirements, including tax filings. Ensure Form 1120S, the S Corporation tax return, is filed annually with the IRS.
Track Stock Basis:
Maintain accurate records of each shareholder's adjusted basis in their stock. This is crucial for calculating gains or losses on distributions or sales of stock.
Regulatory Compliance:
Ensure compliance with securities laws and regulations, which may include state and federal requirements related to the issuance and transfer of stock.
Who is going to issue the stock certificates, how and where to get them?
Stock certificates for an S corporation can be issued by the corporation itself, typically through its officers or a designated corporate secretary.
Here's a detailed guide on who issues them and where to get them:
Issuing Stock Certificates
Corporate Officers:
Who Issues Them: Stock certificates are usually issued by corporate officers, such as the President, Secretary, or other authorized individuals, as specified in the corporate bylaws or resolutions passed by the board of directors.
Role in Issuance: These officers are responsible for signing the stock certificates and ensuring they are issued according to the company’s records and legal requirements.
Corporate Secretary:
Duties: The Corporate Secretary or similar role often maintains the stock ledger and ensures that the issuance of stock certificates aligns with the company’s records.
Record-Keeping: They will also document the issuance of shares in the stock ledger, including details such as shareholder names, the number of shares issued, and the date of issuance.
Obtaining Stock Certificates
Purchase from a Supplier or get them free here is the link: 19 Free Stock Certificate Templates (Word, PDF) ᐅ TemplateLab
Stock Certificate Forms: You can purchase stock certificate forms from specialized printing companies or online suppliers that provide customized stock certificates.
These forms often include security features and space for company details, shareholder information, and authorized signatures.
Suppliers: Common sources include:
Office supply stores: They often offer stock certificate templates and services.
Online printers: Websites like StockCertificate.com or The Corporate Store provide customizable stock certificate templates.
Local printers: Some local print shops offer customized stock certificate printing services.
Customized Certificates:
Custom Design: For a more professional look or to include specific security features, you can work with a printer who specializes in corporate stationery. They can design and print certificates that reflect the corporation’s branding and include necessary legal text.
Issuing and Handling Stock Certificates
Design and Print:
Design Elements: Ensure the stock certificates include essential information such as:
The name of the corporation
The name of the shareholder
The number of shares issued
The par value of the shares (if applicable)
The certificate number
Signatures of authorized officers
Printing: Once designed, certificates are printed and then physically signed by authorized officers.
Distribution:
Deliver to Shareholders: After printing and signing, stock certificates should be delivered to the shareholders. This can be done in person or by mail.
Maintain Records:
Stock Ledger: Ensure that each issuance is recorded in the company’s stock ledger, documenting the details of the certificate issued and the shareholder’s information.
Legal and Compliance Considerations
Compliance: Ensure that the issuance of stock certificates complies with state laws and the corporation’s bylaws.
Legal Requirements: In some jurisdictions, stock certificates may not be required if the corporation uses electronic records for stock ownership. Always check local regulations and consult with a legal professional if necessary.
smith, e. (2024). Eligibility and Election - S Corporations 2024.
