Change Federal Taxation Method (S-Corp and C-Corp Election)

General Information

When a business entity is created by filing a formation document with the Secretary of State, it immediately receives a default tax status based on its business entity type. In some cases, the entity’s tax status may be changed so that the entity retains the liability protection and formality requirements of its type but is taxed in a different fashion. The tax status may only be changed by submitting a filing with the IRS; if the appropriate filing is not made the entity will be taxed according to the default rules. IRS – Possible Repercussions.

Affirmatively choosing a tax status is especially important for limited liability companies because “the federal government does not recognize an LLC as a classification for federal tax purposes.” IRS – Limited Liability Company. Consequently, an LLC must file its tax returns as if it were a Sole Proprietorship, Partnership, C-Corporation, or S-Corporation. Frequently, LLC owners find it more advantageous to be taxed as a Corporation (C-Corp) or as an S-Corp, each of which requires a filing to so elect. But because the S-Corp election is only available to entities with 100 or fewer shareholders, it is an option strictly for small businesses/closely-held companies.

Purpose/Necessity

The purpose of C-Corp or S-Corp election is to achieve federal and state tax savings as compared to the way the business would otherwise be taxed. A C-Corp tax election allows an entity to be taxed as a standard corporation.

An S-Corp tax election is similar to the taxation of a sole proprietorship or partnership. It pays no entity-level income taxes but instead passes its income, losses, deductions, and credits to its members or shareholders to be reported on their personal tax returns. The “S” relates to the fact that its legal authority comes from Subchapter S in the Internal Revenue Code.

There are restrictions on whether an entity may receive S-Corp status. The entity must:

  1. Be domestic (formed under U.S. law)
  2. Have only 1 class of stock (all shares must confer identical rights to distribution and liquidation proceeds but voting rights may be different)
  3. Have no more than 100 shareholders (all members of a family and their estates may be considered a single shareholder under the IRS test)
  4. Have only allowable shareholders (allowable: individuals, tax-exempt organizations, estates, certain trusts; not allowable: corporations, partnerships, non-resident aliens)
  5. Not be an ineligible corporation (bank/thrift institution, insurance company, possessions corporation, international sales corporation)

 

Availability of a Tax Method Change

Default Tax Status

Tax Election Option(s)

Major Benefit to Making Election

Single-Member LLC

Sole Proprietorship

C-Corporation
S-Corporation

  • A C-Corp may reduce corporate income taxes by allocating owner compensation as salary rather than profits
  • An S-Corp may reduce employment/payroll taxes by allocating owner compensation as profits rather than salary

Multi-Member LLC

Partnership

C-Corporation
S-Corporation

  • A C-Corp may reduce corporate income taxes by allocating owner compensation as salary rather than profits
  • An S-Corp may reduce employment/payroll taxes by allocating owner compensation as profits rather than salary

C-Corporation

C-Corporation

S-Corporation

  • An S-Corp may reduce employment/payroll taxes by allocating owner compensation as profits rather than salary

S-Corporation

S-Corporation (election made previously)

C-Corporation

  • A C-Corp may reduce corporate income taxes by allocating owner compensation as salary rather than profits

Frequently Asked Questions

  • If the goal of an S-Corp is for the entity to be taxed similarly to a sole proprietorship or a partnership, why form a corporation or an LLC in the first place?
    • Corporations and LLCs shield their business owners from most debts and liabilities that accrue through running the business. In contrast, the business owners of partnerships and sole proprietorships remain personally liable for such debts and liabilities. Please see business entity type determination for more information.
  • How does a federal taxation election affect the entity’s liability shield?
    • A federal tax election does NOT affect the liability protection afforded its owners. It in no way alters the business entity type, and therefore also has no effect on the formalities required of the entity. It affects only what taxes are owed.
  • How does a federal taxation election affect state tax treatment?
    • Most states tax the entity according to the election. In some cases, a separate election form must be filed with the state. Some states, including the District of Columbia, New Hampshire, and Tennessee, impose regular corporate income taxes on S-Corps. In the few states that do not recognize the election, the entity will be taxed as desired federally but treated differently for state tax purposes.Kentucky tax laws generally comport with federal tax laws and guidelines. In Kentucky, “the administrative and judicial interpretations of the federal income tax law, computations of gross income and deductions therefrom, accounting methods, and accounting procedures… shall be as nearly as practicable identical with those required for federal income tax purposes.” KRS 141.050(1). Kentucky recognizes S-Corp and C-Corp elections and taxes such entities accordingly. No additional filing is required.
  • By when must the S-Corp election be made?
    • At the latest, 2 months and 15 days after the beginning of the tax year the election is to take effect. If the entity is taxed by the calendar year (as most are), the S-Corp election must be made within two and a half months from the date the business begins for tax purposes. See IRC § 1362(b). The IRS has indicated it will allow an entity to be taxed as an S-Corp even if the election was late upon a showing of “reasonable cause.”
  • Is an S-Corp election permanent?
    • No. A business will be forced to relinquish S-Corp status if it takes on over 100 shareholders, adds additional classes of stock, or adds not allowable shareholders. Any disqualifying event will cause automatic termination of the status as of the date of the event. Alternatively, a business may voluntarily determine that it is more advantageous to be taxed as a regular C-Corporation, in which case it may file such an election.
  • By when must the C-Corp election be made?
    • At the latest, 12 months after the election is to take effect, unless the entity is granted late election relief by the IRS.
  • Is a C-Corp election permanent?
    • No. A business entity that has previously made an election to be taxed as a C-Corp may make an election to be taxed as a sole proprietorship or partnership, as appropriate based on its size. Alternatively, such entity could elect S-Corp status.
  • What happens if an LLC does not make an election and the number of members change?
    • The entity will be taxed in accordance with the IRS default rules based on the current number of members. This means a single-member LLC that adds members will automatically be taxed as a partnership while a multi-member LLC that loses members and retains only a single owner will then automatically be taxed as a sole proprietorship.
  • May an LLC change its tax status multiple times?
    • Yes. An LLC can file multiple elections and thereby take advantage of its ability to be classified in four different ways for tax purposes. A single-member LLC that previously elected to be taxed as an S-Corp or a C-Corp may change its federal taxation method to that of a sole proprietorship. Similarly, a multi-member LLC that previously elected to be taxed as an S-Corp or a C-Corp may change its federal taxation method to that of a partnership. There is no filing fee for such election, though there likely will be a tax impact of such a change. An accountant should be consulted in advance of the election.
  • Does the business entity have to inform the state taxing authorities after changing its federal tax status?
    • Yes. The business entity must file an appropriate update/amendment with the revenue department of the state in which it is organized and therefore taxed.

Legal Services Offered and Cost

S-Corporation Election
Legal fees: $100 flat fee
Filing fees and other costs: none
This includes:

  1. Review of business information to ensure readiness for application
  2. Submission of information through IRS Form 2553
  3. Email confirmation of S-Corporation status
  4. Legal advice on maintaining compliance through payment of “reasonable compensation”

If you are ready to get started, please CLICK HERE to enter basic information using our secure online form.

 

C-Corporation Election
Legal fees: $100 flat fee
Filing fees and other costs: none

This includes:

  1. Review of business information to ensure readiness for application
  2. Submission of information through IRS Form 8832
  3. Email confirmation of S-Corporation status
  4. Legal advice on maintaining compliance through C-Corp tax completion

If you are ready to get started, please CLICK HERE to enter basic information using our secure online form.