Let’s talk about year-end tax tips. The first strategy that we’re going to talk about is how to file a late S corp election.
This is a big question I get because many small business owners are eager to join the S corp bandwagon. Countless articles and blogs fill the internet with praise for the S corps. It’s the “one weird trick” of the tax world—at least, it was for many years. The talk about S corps is much more balanced these days.
Can an S corp significantly reduce your tax liability? Absolutely—under the right circumstances. I have an article about S corp thresholds, which you can read here. Let’s get started.
Can you elect to be taxed an S corp for a previous period and a prior tax year?
The short answer is yes, you can file a late election, and in many cases, you can expect to reduce your tax liability. It’s a relatively simple revenue procedure business owners use to file a late S corp election directly with the Internal Revenue Service (IRS) and is included in the tax code as “Rev. Proc. 2013-30.” ¹
Good faith matters. If you combine good faith with concrete steps to look and act like an S corp, the procedure will be much smoother. The issue is justifying late elections, so today’s article will discuss strategies and associated requirements you need to make a strong case for S corp election.
Prepare for additional time and money in administration.
One notable tax advantage of an S corp is that owners and shareholders receive salaries in addition to their share of earnings. However, there is a bevy of rules, requirements, and forms to contend with.
The IRS is amenable to late S corp elections if you come prepared.
The IRS is fairly lenient in granting relief and allowing a corporation to elect to be taxed under S corps status in the year intended. However, reasonable causes vary, and the IRS does not publish a list. Tax journals and court documents show that certain reasonable cause arguments are legitimate.
We’ll discuss reasonable cause in a moment. Remember that late elections are similar to retroactive S corp elections. Both processes have specific rules laid out in detail in IRS Form 2553.² After filing Form 2553, the IRS will send the business either an acceptance or denial letter within 60 days of filing. If the election is accepted, the letter will show the effective date.
Keep in mind S corp stipulations in the context of reasonable cause.
S corp shareholders receive a salary, which must be reasonable. Multiple factors determine what constitutes reasonable compensation, including the duties performed, the volume and complexity of business handled, levels of responsibility, and time commitments.
Profitability and distribution amounts are critical factors that business owners must consider, as well. I’ll expand on this process below.
What is your reasonable cause?
If you want a reasonable cause, behave like an S corp. Come up with honest explanations as to why you filed late and include that information with Form 2553. How about examples of three acceptable answers for a reasonable cause?
Number #1: A business owner or responsible party should have filed the election, but they did not.
Number #2: You did not know that you needed to file an election.
Number #3: You didn’t know you needed to file the election in advance.
See if you meet the basic requirements.
You need to answer “yes” to all of the points below.³
- My business entity is a corporation.
- My business entity is not an S corps solely because the election was not filed on time.
- My business, members/managers, and shareholders have reported income consistent with S corp rules.
- At least 6 months have passed since my business filed a tax return in the tax year you are electing to be treated as an S corps.
How do you address the reasonable compensation requirement?
How do we meet reasonable compensation requirements? After all, you’ve been taking owner’s draws as an LLC. There are quite a few options. You could elect to draw a salary as an LLC and plead with the IRS on the grounds of good faith, but this is risky.
Conduct a reasonable compensation study.
First, a reasonable compensation study must be conducted to determine the fair market value of the services you provide. The IRS recommends that the following items be considered as part of your study:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of bonus payments to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation⁵ ⁶
A reasonable compensation study provides answers to the following questions:
- What would your business offer in compensation to another person who provided the same services you provide?
- What would other businesses in your industry (and in your community) pay you for the services you bring to your business?
Maintain proper meeting minutes.
Documentation is critical to the process of establishing reasonable compensation, and one of the most important pieces of documentation is your meeting minutes.
Record your meetings in a consistent format and include details such as the date, time, individuals present, topics discussed, and action items agreed upon.
Reasonable compensation studies should be conducted annually. I recommend that you evaluate your meeting minutes quarterly for accuracy and thoroughness, as well.
To receive late election relief, act like an S corp.
Conduct business in a manner consistent with your intent to be an S corp from the proposed effective date until the time you file for late relief.
Typically, I see late S corp elections with limited liability companies (LLCs), either because the client’s income has passed a certain threshold, revenue is up, or business is growing.
They are ready to handle the added administrative burden, both in time and cost, associated with an S corporation. In other words, the tax savings outweigh the burden.
Meet the deadlines.
The deadline to file IRS Form 2553 depends on whether you have recently completed your business entity formation or if you’ve been doing business as a corporation for some time.
For newly-formed entities (including LLCs, partnerships, and corporations), Form 2553 must be filed within two months and 15 days from the beginning of the business’s tax year.
Want to file a late S corp election? We can help.
Schedule a discovery call today for late S corp elections and retroactive elections. We can make it work.
Talk soon,
Jeremy A. Johnson, CPA
References
- Internal Revenue Bulletin: 2013-36 | Internal Revenue Service [Internet]. IRS.gov. 2016 [cited 2024 Nov 16]. Available from: https://www.irs.gov/node/49746#RP-2013-30
- Instructions for Form 2553 [Internet]. IRS.gov. 2020 Dec [cited 2024 Nov 12]. Available from: https://www.irs.gov/pub/irs-pdf/i2553.pdf
- Internal Revenue Service. Late Election Relief | Internal Revenue Service [Internet]. www.irs.gov. 2024. Available from: https://www.irs.gov/businesses/small-businesses-self-employed/late-election-relief
- Wage Compensation for S Corporation Officers [Internet]. 2008 Aug [cited 2024 Dec 15]. Available from: https://www.irs.gov/pub/irs-news/fs-08-25.pdf
- S Corporation Compensation and Medical Insurance Issues | Internal Revenue Service [Internet]. www.irs.gov. 2024. Available from: https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues#reasonable