S Corporation Overview

Today TaxMama® hears from someone in the TaxQuips Forum, who keeps asking similar questions about California LLCs and Canadian Limiteds owning an S Corp.  So, let me tell you a little bit about S Corporation rules.

 Dear Family,

An S corporation is not for everyone. First of all you must meet the basic criteria:

To qualify for S corporation status, the corporation must meet the following requirements:

  • Be a domestic corporation
  • Have only allowable shareholders
    • including individuals, certain trust, and estates and
  • Have no more than 100 shareholders
  • Have one class of stock (which means that all owners share profits proportionately)
  • Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.
  • may  not include partnerships, corporations or non-resident alien shareholders (in other words – no Canadian or  foreign shareholders, no S corporation shareholders.)

In order to become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation (PDF) signed by all the shareholders by the 15th day of the 3rd month after formation.

In addition, shareholders who own more than 2% of the business are not entitled to regular employee benefits. Having the company pay for your health care requires excessive paperwork.

The working officers/owners/shareholders of the corporation cannot simply draw out money whenever they feel like it. They must be on payroll, getting paid a reasonable salary. (Note: Reasonable is undefined, but the IRS knows when it’s not reasonable – got it?)

Now that the IRS is cracking down on S corps that underpay their officers, there aren’t many good reasons to form them any longer.

For more information, visit the IRS page about S corps.

And remember, you can find answers to all kinds of questions about S corporations, and other tax and business issues, free. Where? Where else? At www.TaxMama.com.


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One thought on “S Corporation Overview

  1. owen@april15th.com says:

    Hi, TaxMama. I read your posts every day. They are very valuable and real-world.

    I’m writing today to offer a response to your comment that, “Now that the IRS is cracking down on S corps that underpay their officers, there aren’t many good reasons to form them any longer.”

    I respectfully disagree with your assertion that there aren’t many good reasons to form them any longer. On the contrary, I believe that there are just as many reasons to form them as before the IRS ‘crack down.’ If that is the only reason why they are not good a good tax-planning strategy for businesses, I disagree. Here’s why:

    As you well know, the IRS is cracking down on ABUSIVE S-corps that pay little to no wages or are not paying reasonable wages. If reasonable wages are paid, then an S-corporation makes sense for the very same reasons as they did before the IRS ‘crack down’.

    I’m certain that you’ve seen the last few cases of IRS reclassifying wages. Some are very unfavorable to taxpayers, but the last one actually was pretty ‘reasonable’ in the way it approached the subject (Herbert v. Comm’r, T.C. Summary 2012-124 (12/26/12).)

    That having been said, it is often difficult to prove what is actually a reasonable wage and what is not. It depends on a variety of factors such as time spent performing services, experience, training and others. A thorough analysis by a qualified tax professional would be in order prior to establishing wages for a shareholder-employee. I believe that a thorough analysis of the shareholder-employees situation is in order so that a defensible position can be established should the IRS question the reasonable wage issue.

    Now, if you had said that Congress was considering limiting the wage vs. distribution by classifying all wages and distributions as wages, that would have made the argument slightly more compelling. As you know, that is what Congress has been considering for the past decade in an effort to close the tax gap. Most efforts in this regard include the provision that it would only apply to professional s-corps that rely on the services of less than 3 professionals. However, this is unlikely to pass due to a variety of factors affecting Congress’ ability to get anything done. Even so, if a provision such as this were to pass, it would make “solo” S-corps slightly less attractive from a tax standpoint. There would still remain the asset protection angle, which should a a major factor influencing the decision to become a corporation and elect the “S” tax status in the first place.

    And, not that this should be an overriding concern, but the number of reasonable wage audits, while increasing, is still extremely low compared to other types of entities.

    In summary, and respectfully, there may be substantive reasons why formation of an S-corporation is not the best advice. I don’t believe that the IRS crack down is one of them.

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