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Election of “Subchapter-S” for a Corporation

The election of Subchapter S permits the income of the S corporation to be taxed to the shareholders of corporation rather than to the corporation itself, except as noted below under Taxes an S Corporation May Owe.

Who May Elect

A corporation may elect to be an S corporation only if it meets all of the following eight tests:

  1. It is a domestic corporation.

  2. It has no more than 75 shareholders.

  3. Its only shareholders are individuals, estates, exempt organizations described in section 401(a) or 501(c)(3), or certain trusts described in section 1361(c)(2)(A).

  4. It has no nonresident alien shareholders.

  5. It has only one class of stock (disregarding differences in voting rights).

  6. It is not one of the following ineligible corporations:

    1. A bank or thrift institution that uses the reserve method of accounting for bad debts under section 585,

    2. An insurance company subject to tax under the rules of subchapter L of the Code,

    3. A corporation that has elected to be treated as a possessions corporation under section 936, or

    4. A domestic international sales corporation (DISC) or former DISC.

  7. It has a permitted tax year as required by section 1378 or makes a section 444 election to have a tax year other than a permitted tax year. Section 1378 defines a permitted tax year as a tax year ending December 31, or any other tax year for which the corporation establishes a business purpose to the satisfaction of the IRS.

  8. Each shareholder consents as explained in the instructions for column K.

A parent S corporation can elect to treat an eligible wholly-owned subsidiary as a qualified subchapter S subsidiary (QSub). If the election is made, the assets, liabilities, and items of income, deduction, and credit of the QSub are treated as those of the parent. To make the election, get Form 8869, Qualified Subchapter S Subsidiary Election. If the QSub election was not timely filed, the corporation may be entitled to relief under Rev. Proc. 98-55.

Taxes an S Corporation May Owe

An S corporation may owe income tax in the following instances:

  1. If, at the end of any tax year, the corporation had accumulated earnings and profits, and its passive income under section 1362(d)(3) is more than 25% of its gross receipts, the corporation may owe tax on its excess net passive income.

  2. A corporation with net recognized built-in gain (as defined in section 1374(d)(2)) may owe tax on its built-in gains

  3. A corporation that claimed investment credit before its first year as an S corporation will be liable for any investment credit recapture tax.

  4. A corporation that used the LIFO inventory method for the year immediately preceding its first year as an S corporation may owe an additional tax due to LIFO recapture. The tax is paid in four equal installments, the first of which must be paid by the due date (not including extensions) of the corporation’s income tax return for its last tax year as a C corporation.

When To Make the Election

Complete and file Form 2553 (a) at any time before the 16th day of the 3rd month of the tax year, if filed during the tax year the election is to take effect, or (b) at any time during the preceding tax year. An election made no later than 2 months and 15 days after the beginning of a tax year that is less than 2 1 /2 months long is treated as timely made for that tax year. An election made after the 15th day of the 3rd month but before the end of the tax year is effective for the next year. For example, if a calendar tax year corporation makes the election in April 2001, it is effective for the corporation’s 2002 calendar tax year.

Acceptance or Nonacceptance of Election

The service center will notify the corporation within 60days if its election is accepted and when it will take effect. The corporation will also be notified if its election is not accepted.

End of Election

Once the election is made, it stays in effect until it is terminated. If the election is terminated in a tax year beginning after 1996, IRS consent is generally required for another election by the corporation (or a successor corporation) on Form 2553 for any tax year before the 5th tax year after the first tax year in which the termination took effect. See Regulations section 1.1362-5 for details.

Download the IRS Instructions

 

 

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Last modified: February 19, 2007