For tech startups keen on leveraging the unique benefits of an S Corporation – namely pass-through taxation and the opportunity to issue shares – the path to achieving this status involves navigating a complex legal and procedural landscape. The election to S Corporation status requires the submission of specific documents to the Internal Revenue Service (IRS),compliance with stringent legal requirements, and an understanding of the potential legal implications of missteps.
The journey to becoming an S Corporation begins with the filing of IRS Form 2553, "Election by a Small Business Corporation". The form requires detailed information about the corporation and its shareholders, including the corporation’s name, address, tax year, and the consent of all shareholders. It is imperative that tech startup founders file this form in a timely manner. Specifically, it should be filed no more than two months and 15 days after the beginning of the tax year in which the election is to take effect.
The necessity of a timely filing was highlighted in multiple cases, and while late election is possible, the IRS holds LLCs to a higher standard when electing as an S Corporation.
The legal requirements for an S Corporation are also essential for tech startups to consider. These include restrictions on the number of shareholders to 100, excepting family, on the type of shareholders to US persons, on the stock to a single class of stock, and companies are limited to U.S. operations. Additionally, LLC electing as an S Corporation must generate revenue directly, as passive revenue and cash flow earned by S Corporations is will not earn benefits of taxation, and should an S Corporation have more than 25% of total revenue from passive sources for 3 consecutive tax years, it will loose its S Corporation status. Violation of these requirements may result in a revocation of S Corporation status.
Incorrect S Corporation elections can have significant legal implications. The most immediate effect is a potential loss of S Corporation status, leading to a default to C Corporation status. This would introduce double taxation – at both the corporate and shareholder levels – a scenario that most tech startups seek to avoid when choosing S Corporation status.
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