Special Trivia Question at the End!
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Electing S corporation status can be a valuable tax strategy for physicians with profitable 1099 or practice income. But the election itself is deceptively simple. Form 2553 is only a few pages long, yet small procedural mistakes can create problems that do not become apparent until months—or even years—later.
Here are six of the most common ways I see S corporation elections go wrong.
1. The election wasn't filed on time
To have an S election effective for a particular tax year, Form 2553 generally must be filed within 2 months and 15 days after the beginning of that tax year.
For an existing calendar-year business seeking S corporation status effective January 1, that normally means March 15.
For a newly formed business, the deadline is generally 2 months and 15 days after the effective date of the election.
Fortunately, missing the deadline is often fixable. The IRS provides late-election relief under Revenue Procedure 2013-30 when the business intended to be an S corporation, otherwise qualifies, and has reasonable cause for filing late.
The problem usually isn't that the mistake is impossible to fix. It's that nobody realizes the election was late until much later.
2. The election was sent without good proof that the IRS received it
Form 2553 can be mailed or faxed to the IRS. But when I am handling an election, I prefer certified mail with tracking and proof of delivery.
Why? Because months later, "I know we sent it" is not nearly as useful as documentation showing when it was mailed and when the IRS received it. A fax confirmation is not legal proof, and if the IRS says “my dog ate your Form 2553,” there isn’t much you can do.
The IRS normally sends a letter confirming whether the S election was accepted or rejected. That letter should be saved permanently with the entity's tax records.
A particularly dangerous situation occurs when the taxpayer never receives an acceptance letter but assumes everything is fine because the IRS accepts the first Form 1120-S. That does not necessarily prove the election was processed. In some cases, the IRS may process an S corporation return while the election is supposedly pending, only for the problem to surface when a later return is rejected.
The Form 2553 instructions also permit certain late elections to be submitted with the first S corporation return. While technically permissible, I generally prefer to resolve the election before relying on the tax-return filing process to straighten it out.
3. The late election was prepared incorrectly
Late S elections have their own procedural requirements. The Form 2553 instructions specifically require the following language at the top of the first page:
"FILED PURSUANT TO REV. PROC. 2013-30"
The filing should also include a reasonable-cause statement explaining why the election was not timely filed and describing the steps taken once the mistake was discovered.
This is usually a very fixable problem. If the IRS rejects a deficient late election, a properly prepared Form 2553 can often simply be resubmitted. But a late election should not be treated like an ordinary Form 2553 with a different date on it.
4. A community-property spouse didn't consent
This one surprises people.
For S corporation purposes, a spouse who has a community-property interest in the shares may need to provide shareholder consent even if that spouse's name does not appear on the LLC membership records. This most commonly becomes an issue for married business owners in community-property states.
Fortunately, missing consent is generally much easier to correct than losing S corporation eligibility altogether. The IRS has procedures for supplying the missing shareholder consent.
5. The business has an ineligible shareholder
An S corporation cannot have just any shareholder.
Permitted shareholders generally include:
U.S. citizens or resident individuals
Certain estates
Certain trusts
Certain tax-exempt organizations
An S corporation generally cannot have a nonresident alien shareholder, and most corporations, partnerships, and LLCs cannot be shareholders. There is also generally a 100-shareholder limit.
The 100-shareholder limit isn’t really a concern with small physician practices. The more likely scenarios that could inadvertently terminate an S election are:
1. Selling your interest to a nonresident alien
2. Allowing a non-resident alien to acquire a community interest through marriage (only in community property states).
Yep, you read that right. The S Corp can inadvertently terminate if any shareholder sells to a non-resident alien, marries a non-resident alien, or sells to someone who is married to a non-resident alien.
If you remember only one thing from this article, aliens are dangerous.
6. The operating agreement creates a second class of stock
An S corporation may have only one class of stock.
That does not mean every shareholder must own the same percentage. One physician can own 70% and another 30%. The important rule is that all outstanding shares must generally have identical rights to distributions and liquidation proceeds.
This is particularly important when an LLC originally taxed as a partnership elects S corporation status.
Partnership operating agreements commonly contain provisions allowing:
Special allocations
Preferential distributions
Different economic rights among members
Those provisions may work perfectly well for partnership taxation—but create a problem once the LLC wants to be taxed as an S corporation. Before making the election, the operating agreement should be reviewed and, when necessary, amended so that the owners' economic rights comply with the S corporation one-class-of-stock requirement.
TaxSmart Takeaway
Form 2553 looks simple. The rules surrounding it are not.
For physicians, the biggest risks are usually not obscure tax-law issues. They are mundane procedural problems: a missed deadline, missing consent, an old operating agreement, or an election that was mailed but never confirmed.
My rule is simple:
File the election correctly, document when the IRS received it, and keep the IRS acceptance letter permanently.
That little bit of housekeeping can prevent a surprisingly expensive mess several years later.
Special Trivia Question!
As described earlier, an eligible S Corp cannot have a “second class of stock.” Three of these situations are examples that would disqualify an S Corp. Which of these does NOT create a second class of stock that would disqualify the S Corp election?
A. Voting and non-voting shares of stock
B. Preferred and secondary distributions of stock
C. Liquidation preferences (i.e. some stock shares are entitled to higher percentages of liquidation proceeds)
D. Distribution percentages that do not match ownership percentages
Click here for the answer!