If you’ve read about S Corps and wish you had turned your business into an S Corp sooner, you may be in luck. With a retroactive S Corporation election, sometimes called a late S Corp election, you can elect S Corp taxation effective at an earlier date, which may lead to significant tax savings.
Here’s a closer look at how retroactive S Corp elections work, why you may want one, and the rules you need to follow to make a retroactive S Corp election work for your business.
Why choose an S Corp?
Choosing S Corp status can offer significant advantages for a small business, particularly when it comes to taxes. One of the key opportunities is eliminating self-employment tax while also avoiding the double taxation that comes with the corporate tax of C Corporations.
In an S Corp, profits and losses pass through to shareholders’ personal tax returns, meaning the business isn’t taxed separately. However, you must pay yourself a reasonable salary. An S Corp owner pays Social Secuirty and Medicare taxes on the reasonable salary rather than on the entire business profit.
Since the S Corp election must be layered onto a legal entity (like an LLC or corporation), you will continue to enjoy the liability protection that exists from the LLC or corporation. Existing as an S Corp requires some additional administrative effort, like payroll requirements and filing a tax return for your S Corp, but an S Corp that stays in compliance can lead to potential income tax savings.
What is a retroactive S Corporation election?
A retroactive S Corporation election is a process that allows a business to change its tax status to S Corp for a previous period, potentially a prior tax year. This involves filing IRS Form 2553, (Election by a Small Business Corporation) and requesting S Corp status, often effective at the beginning of a tax year, to benefit from S Corp tax advantages for a past period.
Unlike a standard S Corp election, the key distinction lies in timing. While the standard election must occur within the initial 2.5 months of the intended tax year or the preceding tax year, circumstances may lead to a delayed election.
To accommodate such cases, the IRS provides a Late Election Relief process, allowing business owners to elect S Corp status beyond the standard timeframe, backdating the election for retroactive treatment. To be eligible, businesses must show reasonable cause for their failure to file on time.
Business owners opting for retroactive S Corp status can capture tax benefits, like eliminating self-employment taxes, by restructuring their tax obligations for a prior period. A retroactive S Corp election can be a lucrative tax savings opportunity, however comes with its own complexities and risks.
Seeking guidance from a tax professional is advisable to navigate the nuanced filing requirements and ensure compliance with IRS rules. Also, state tax laws vary and may have different rules regarding S Corp status and retroactive elections.
Pros and cons of a late S Corp Election
Pros of a retroactive S Corp election
Tax savings: A business can benefit from pass-through taxation and allows business owners to eliminate self-employment tax.
Flexibility in tax planning: Allows an opportunity to test or prove growth goals and profit projections.
Correction of oversight: Offers an opportunity to correct inadvertent lapses in making the initial S Corp election, based on a reasonable cause.
Cons of a retroactive S Corp election
Complexity and compliance risks: Filing for retroactive status can be complex, requiring stringent adherence to IRS rules regarding eligibility. Retroactive status impacts all shareholders. All shareholders need to consent to the election and report their income in a manner consistent with S Corp status for the tax year the election should have been made.
Administrative burden: Involves additional paperwork and administrative tasks to retroactively generate financial records, payroll to meet reasonable salary requirements and S Corp business tax return filings.
Other tax implications: There may be other tax implications, such as changes to the deductibility of certain business expenses or the impact on qualified business income deductions.
Who is eligible for a retroactive S Corp election?
The IRS imposes precise rules for which businesses can retroactively opt for S Corp taxation. To be eligible for S corporation status, an entity must meet key criteria, which include:
- Domestic entity: It must be a domestic corporation or eligible entity, such as an LLC.
- Type and number of shareholders: An S Corp can have no more than 100 shareholders. Shareholders must be individuals, estates, certain exempt organizations, or specific trusts. Nonresident aliens cannot be shareholders of an S Corp
- Tax year requirements: The entity must adopt an acceptable tax year structure, such as a year ending December 31 or a natural business year
If you’re a solo business owner with a single member LLC, you can file Form 2553 to get S Corp taxation retroactively. The retroactive election would allow your LLC to be taxed as an S Corp.
How to make a retroactive S Corp election
Here’s a simple 3-step guide to making a retroactive S Corp following IRS rules:
- Determine eligibility and intent: Ensure your entity is eligible for S Corp status and intended to be classified as such but missed the deadline for filing Form 2553.
- File the election form following the Late Election Relief process: Complete and file IRS Form 2553 within three years and 75 days of the intended effective date of your S Corp election. If you are filing beyond the 2.5 month rule, you must follow the IRS late election relief process, which includes an explanation of the reasonable cause on Form 2553, Part I, Section I. A header at the top of the first page of Form 2553 stating Filing Pursuant to Rev. Proc. 2013-30 is also required.
- Consistent reporting: Ensure that the entity and all its shareholders have reported their income consistent with S Corporation status for the year the election should have been made and all subsequent years.
The rules are very complicated for who can file and how to handle taxes when you’ve retroactively switched to an S Corp. When in doubt, it’s wise to work with a CPA or other tax professional who can guide you through the process and ensure you are following the most up-to-date IRS guidelines.
Moving forward with a Retroactive S Corp Election
If you find yourself wishing you had embraced S Corp benefits earlier, a retroactive S Corporation election might be the solution. While you’re required to follow the IRS guidance of filing the election within 2.5 months, the Late Election Relief process allows business owners to still capture the benefit of an S Corp retroactively, as long as they’re committed to meeting retroactive compliance requirements.
The decision to pursue a retroactive S Corp election is a strategic move that requires careful consideration, planning and detailed execution. Consulting with a tax professional before moving forward with a retroactive election will help you anticipate all the work that needs to be done to keep your business in good-standing with the IRS.
If you’re a Business-of-One and contemplating this transition, Collective may be the place for you.
