Electing S Status – It’s Not Just an Accounting Issue

Many small businesses start out as LLCs. It is easier to form and run. There is no company tax return and all the income passes through to the owners.

Sometimes business takes off, and the accountant recommends having the LLC taxed as an S-corporation for tax savings.

From an accounting point of view, this could not be easier. It’s sometimes called a “check the box” election. You file Form 2553 with the IRS. It is three pages long and most companies don’t even need page 3. So simple, so easy.

However, there are many legal requirements to being an S-corp. The shareholders have to be US citizens or Green Card holders.

There can only be 100 shareholders, and they must in most cases be actual people rather than limited liability companies, trusts, or other corporations. And the place where many unassuming business owners trip up – there can be only one class of stock.

The LLC’s operating agreement likely contains partnership tax provisions (because a multi-member LLC is taxed as a partnership) that essentially create two classes of stock when the LLC elects S status.

If you improperly elect S status, not only are you not an LLC being taxed as an S-Corp, but you also elected to convert your LLC to a corporation when you elected S-status. You are now expected to file a corporate tax return and pay taxes at the corporate level.

When you discover the mistake years down the road, the consequences can be costly.

Before you and your accountant change your tax status, check with a corporate attorney.