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As a business owner, you may have heard about the S-corporation and what it can (possibly) do for your company. Unfortunately, much of the information available about S-corps falls into two categories: the misleading or the incredibly technical.

This is the first of a two-part look at the most common misconceptions about S-corporations.

While no article can conclusively tell you if the S-corp is the right path for your business, hopefully quality information will help you steer in the right direction.

Misconception #1: An S-Corp is a Type of Corporation

This is the most common misconception, and an easy one to make given the name “S-corp”. But an S-corp isn't actually a corporation at all.

A corporation is a business entity separate from its owners. It is created by filing formation documents with a state agency, such as a Secretary of State.

An S-corp, however, is a tax designation granted by the Internal Revenue Service (IRS). You can't form an S-corp. It isn't an entity. What you can do is apply for S-corp status by filing the Form 2553 (Election by a Small Business Corporation). If the IRS approves your application, the election alters the way your company is taxed.

In reality, the term “S-corporation” is nothing more than terminology.

Many entrepreneurs are misled by well-meaning articles comparing LLCs to S-corps, or Corporations to S-corps. Such comparisons can be distracting, because the truth is that both LLCs and corporations can file for an S-corp election. Doing so doesn't change the nature of your entity (an LLC that applies for S-corp status is still an LLC), it simply alters how the IRS taxes your business.

Misconception #2: Any Business Can Elect to Be an S-Corp

You must apply to the IRS to be granted S-corp status, but there are stringent requirements. Not every company is eligible (but the majority of companies are).

S-Corp eligibility depends on the following factors (which also apply to LLCs and other entity types):

  • No more than 100 shareholders
  • Shareholders cannot be nonresidents or corporations
  • Must be a domestic company
  • All shareholders must consent to the election
  • Can issue only one class of stock
  • Company cannot be a member of an affiliated group

These eligibility guidelines apply to your company both before and after you are granted S-corp status. If the IRS grants approval when you have 80 shareholders and you expand to 120, you are no longer eligible.

The IRS advises that you submit the Form 2553:

·       No more than two months and 15 days after beginning the tax year that the election is to take effect, or

·       At any time during the tax year preceding the tax year it is to take effect

It is possible to file late, however. The IRS has rules for late filings, which it calls Late Election Relief. In order to be eligible for LER, you must have intended to be an S-corp, be an eligible entity for S-corp election, and have failed to qualify only because you did not file the Form 2553 on time.

You will need reasonable cause for failure to file on time, and both your company and your shareholders must have filed your previous taxes as if you were operating an S-corp.

When filing the Form 2553 for late election, you must write within the top margin: Filed Pursuant to Rev. Proc. 2013-30.

Misconception #3: All States Treat S-Corps the Same

S-corp status is granted at the federal level, but not every state recognizes the designation or treats it the same way.

One of the most significant benefits of S-corp election is that it removes double-taxation. Corporations are generally taxed twice: at the entity level and on dividends issued to shareholders. A corporation like Cocoa-Cola pays a corporate tax at the state level, and when its shareholders receive dividends they must pay taxes on their earnings on their own income taxes.

S-corp election removes entity-level taxation.

Some states, however, ignore S-corp elections and tax businesses anyway. These states are New Hampshire, Tennessee, Texas and Washington DC. Louisiana does the same thing, but allows corporations to exclude from taxable income any portion shareholders have already paid in state income tax.

Other states will recognize S-corp status, but only if you file with the state itself. These states include: Arkansas, New Jersey, and New York.

An S-corp election doesn't negate any state-level franchise tax, business privilege tax, or excise taxes. These fees must still be paid to states, regardless of your standing with the IRS.