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Avoid These Common Mistakes When Converting to an S Corporation

Oct 03, 2022

At first glance, the corporate tax rules for forming an S corporation appear simple. However, they are not.

Basic Requirements

Here is what your business must look like when it operates as an S corporation:

  1. Must be a domestic corporation.
  2. Must have fewer than 100 shareholders.
  3. Shareholders can only be people, estates, and certain types of trusts.
  4. All stockholders must be U.S. residents.
  5. You can only have one class of stock.

Sounds simple, right? What often appears simple on the surface is not so simple at all.

Mistakes about the Requirements

Some of the rules are hidden. If you violate one of them, your S corporation reverts to a regular C Corporation, and this result could be horrible.

Here are some hidden rules that most likely apply to you.

Don't Forget Your Spouse

 If you live in a community property state, your spouse by reason of community property law may be an owner of your corporation. This can be true whether or not your spouse has stock in his or her own name.

If your spouse is an owner, your spouse has to meet all the same qualification requirements you do. This can raise two issues:

  1. If your spouse does not consent to the S corporation election on Form 2553, your S corporation is not valid.
  2. If your spouse is a non-resident alien, your S corporation is not valid.

Converting an LLC to an S Corporation

Method 1. To convert your LLC to an S corporation for tax purposes, you can use a method we call “check and elect.” It’s easy—just two steps. First, you “check” the box to make your LLC a C corporation. Then, you “elect” for the IRS to tax your C corporation as an S corporation. Here’s how you take the two steps:

  1. File IRS Form 8832 to check the box that converts your LLC to a C corporation.
  2. Then file Form 2553 to convert your C corporation into an S corporation.

Method 2. Your LLC can skip the C corporation step and directly elect S corporation status by filing Form 2553.

Loans That Exterminate S Corporation Status

Don’t make a bad loan to your S corporation. With the wrong type of loan, you enable the IRS to treat that loan as a second class of stock that disqualifies your S corporation.

Small loans are okay. If the loan is less than $10,000 and the corporation has promised to repay you in a reasonable amount of time, you escape the second-class-of-stock trap.

Larger loans are more closely scrutinized. If you have a larger loan, your loan escapes the second-class-of-stock trap if it meets the following requirements:

  1. The loan is in writing.
  2. There is a firm deadline for repayment of the loan.
  3. You cannot convert the loan into stock.
  4. The repayment instrument fixes the interest rate so that the rate is outside your control.

If you are thinking of converting to or forming an S corporation and want to talk to us, please call us on our main line at (218) 491-4002 or schedule a free consultation online for a day and time that works for you..

If you want to improve your business situation, get assistance now. Schedule your free consultation today or give us a call at (218) 491-4002. We're here to help!

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