At first glance, the corporate tax rules for forming an S corporation appear simple. But do not be fooled – they are not. In this blog post, we will explore seven of the most common mistakes made when converting to an S corporation or S corp. By avoiding these mistakes, you can save yourself a lot of headaches (and money) down the road.
S Corp Mistakes to Avoid
#1 Overlooking Eligibility Requirements
To be eligible to convert to an S corp, your business must meet certain requirements with respect to both its shareholders and its assets.
- Only a domestic corporation can be classified as an S Corp.
- The S corp must have fewer than 100 shareholders.
- Only people, estates, and specific types of trusts can be S corp shareholders. All stockholders must be U.S. residents.
- The S corp is limited to only one class of stock.
If an S corporation fails to follow the regulations, it will revert to a C corporation for three years. This could have significant tax implications, so it is important to make sure you are in compliance from the get-go.
#2 Forgetting about Their Spouse
If you live in a state with community property laws, your spouse may own part of your corporation. This may be the case whether or not your spouse has stock in his or her own name.
If your spouse is an owner, they have to meet the same qualification requirements as you. This can raise two issues:
~ Your S corporation is not legal if your spouse does not agree to the form 2553 election.
~Your S corporation is not valid if your spouse is a non-resident alien.
The following are the only community property states in the United States:
- New Mexico
Community property law applies to domestic partnerships in three states— California, Nevada and Washington.
In several other states, spouses can decide to opt into a community property system or designate certain assets as community property. The states that allow this are Alaska, Florida, Kentucky, Tennessee and South Dakota.
Make sure you check your state’s community property laws before filing your S corporation paperwork so you are aware of these implications.
#3 Improperly Converting an LLC to an S Corporation
Follow these instructions below to properly convert your LLC to an S corporation.
Method 1 – To convert your LLC to an S corporation for tax purposes, you can use a method we call “check and elect.”
- File IRS Form 8832 to check the box that converts your LLC to a C corporation.
- Then file Form 2553 to convert your C corporation into an S corporation.
Method 2 – Your LLC can skip the C corporation step and directly elect S corporation status by filing Form 2553.
#4 Making a Bad Loan to Your S Corporation
You offer the IRS permission to see your S corporation as a second-class stock that disqualifies it, if you get the wrong sort of loan.
Small loans are okay. If the loan is for $10,000 or less and the corporation has committed to repaying you in a timely manner, you won’t get stuck with second-class stock.
Larger loans are more closely observed. If your loan is on the larger side, it can avoid becoming second-class stock if it meets these requirements:
- The loan contract is in writing.
- The loan must be repaid by a specific date.
- It is impossible to convert the loan into stock.
The interest rate is fixed by the repayment instrument, which means you have no influence over it.
#5 Not Filing at the Right Time
Your business needs to meet the S corporation requirements on the day it files for status.
Example. Suppose you want your business to be an S corporation on January 1, 2023. If you file your election in 2022 and elect January 1, 2023, as your effective date for the election, the IRS will look to see if you meet the requirements as of that 2022 day when you filed the election.
What if you want to be an S corporation but you do not file the form before the end of the year? No problem. The tax code gives you the first two months and 15 days of the next year to file the election and have it become effective retroactively on the first day of the year.
For a calendar-year business, this means file by March 15 to make the election effective on January 1.
But to file in this expanded period, you must meet the requirements for S corporation status for the entire year, even the period before you filed the election.
You also must get the consent of everyone who held stock in your corporation for that year.
- Example 1: Suppose you want to convert your business to an S corporation in 2023. You can file your election as late as March 15, 2023. However, your business must meet all the S corporation requirements as of January 1, 2023.
- Example 2: Continuing with the example above, suppose you are in a community property state and you get divorced in February 2023. You need your ex-spouse’s consent to the S corporation election because he or she was a shareholder in January (during the time of your marriage).
#6 Beware of Extra Taxes for Some C Corporations
If you run a company as a C corp, you will have to deal with some unique challenges when you convert to an S corporation.
- Built-in gains tax. You may be liable for huge taxes if your C corporation’s assets are worth more than the basis.
- Loss of tax attributes. C corporations that have loss carryover or minimum tax credits often cannot utilize them when they transition to an S corporation.
- LIFO recapture. If your C corporation utilized the LIFO (last in, first out) method of accounting for its inventories, you may be subject to a recapture tax.
#7 Forgetting About Passive Investment Income
If your previous C corporation had earnings and profits, you may be charged a higher tax if those amounts exceed 25 percent of your S corporation’s income comes from passive investment income (generally, income from: royalties, rents, dividends, interest, and annuities).
The bottom line is that there are a number of potential pitfalls when converting your business to an S corporation status. However, by working with a qualified tax strategist, and being mindful of the potential mistakes listed above, you can minimize the risk of problems arising down the road. Rushing into a conversion without taking the time to fully understand the implications could cost you dearly in terms of both time and money. So take your time, do your research, and make sure you’re prepared before making the switch.
Jose A. Ramirez is an experienced and sought-after tax strategist who helps real estate investors through the process of converting to S-Corporations. He specializes in Short-Term Rentals such as AirBNB and VRBO, Landlords, Wholesalers, Rehabbers, Flippers, Real Estate Brokers, and Realtors. Schedule an appointment with Jose A. Ramirez for any additional questions you may have about this recent event. Make sure you are subscribed to the Advanced Tax Advisors email list so you can receive current events just like this in the future.