Why “Forming an S-Corp” Isn’t Possible

I often run into businesses that say “I want to form an S-corp” or “I am an S-corp.”  There is some degree of misunderstanding in this that I want to try to clear up.  Hopefully I won’t muddy the waters even further.  Here goes…

A business entity resides simultaneously in two different worlds – the legal world and the tax world.  You first form an entity, like an LLC or a corporation, at the state level.  This usually involves filing articles of organization or incorporation with the Secretary of State.  Once you do that, you have formed a legal entity, and the IRS will come a’knockin’.

Soon after forming your entity, you will receive a notice from the IRS asking you to complete Form 2553 – Election by a Small Business Corporation.  Don’t let the term “Corporation” throw you – you’ll receive this notice even if you’re an LLC (limited liability company).  This is when you determine how your entity will be taxed by the IRS.

At this point I always refer my clients to a CPA.  There are self-employment tax considerations that I’m simply not qualified to discuss.  As a corporation, you can elect to be taxed as a C-corporation or as an S-corporation.  As an LLC, you can elect to be taxed as a sole proprietorship, as a partnership, as a C-corporation OR as an S-corporation.

You cannot make the S-corporation election (or any other tax election) without having FIRST formed an entity.  If you don’t believe me, check the instructions for Form 2553 under “Who May Elect.”

Finally and maybe most importantly, once you’ve met with a CPA who’s advised you on the proper election to make, you must file this paperwork with the IRS in time – within two months and 15 days after the beginning of the tax year you want it to apply, or at any time during the tax year PRIOR to the tax year in which you want it to apply.

It’s June now.  If you were to file the paperwork now, the earliest the election would be effective is for next year’s tax return.  This is why I advise all my clients to consult with a CPA BEFORE they come to me to form their entity.  Not only do you want to make the right decision on the tax election, but you need to file the proper paperwork in time.

When I started my first business, I took advice from a bookkeeper and didn’t make this election in time.  It took three years of begging and groveling to get the IRS to make the election retroactive.  And my CPA had to pull some strings.  The lesson?  Make this decision before forming the entity so that when you receive the form 2553 from the IRS, you’re ready.

To summarize…

The LLC or corporation refers only to your legal status – these types of entities create a corporate veil which protects you from being held personally liable in lawsuits filed against your business.

The S-corporation or C-corporation election refers to how the IRS will treat your entity for tax purposes.

You must create a legal entity before you can make a tax election.

I hope I haven’t further muddied the waters.