S Corporation Update: The Business Entity Continues to Grow in Popularity but Requires Attention to Its P's and Q's

EXECUTIVE SUMMARY * S corporations have become the dominant business entity type, in part because requirements for electing the status have been relaxed and clarified. * An S corporation may now have more shareholders because certain family members may be counted as a single shareholder. * When an LLC files form 2553 to elect S status, the form serves as an election to be taxed as a corporation as well. * IRS has approved a tax-free conversion of an S corporation into an LLC without loss of S status. * Procedures now are clearer for an S corporation making charitable contributions of appreciated property. * Regular corporations electing S status still must wrestle with the potential built-in gains (BIG) tax, and larger S corporations must file the new schedule M-3. ********** By some accounts, the advent of S corporations in the late 1950s was the most notable revolution in American tax policy since the Revolution. And it's easy to see why: S corporation owners can protect themselves against personal liability and have their income and gains taxed only once, as opposed to the double exposure of C corporations and their owners at the corporate level and again on individual returns. In 1997, S corporations became the most common type of entity filing a corporate return with the IRS. Since then, their numbers have continued to grow, reaching about 3.6 million and making the S corporation the most popular corporate entity in America. The cornerstone of America's small business community, the S Corporation Association of America calls it. Although the structure resting on that cornerstone has been relatively stable, CPAs must reckon with several legal and regulatory developments in recent years that affect such areas as electing and maintaining S corporation status, limits on flow-through of losses, basis issues, payroll taxes, built-in gains, annual returns and international issues. CPAs advising businesses must keep informed about these changes, which affect many aspects of governance and operation. Here's an overview of how the S corporation landscape has evolved, with some new landmarks and a few extra bends in the road to business success. REQUIREMENTS FOR ELECTING AND MAINTAINING STATUS Shareholder limit. In 2004, Congress increased the maximum number of shareholders in an S corporation to 100 and modified the law to allow certain family members with a common ancestor to be treated as a single shareholder. As the IRS advised in notice 2005-91, any family member can make the election by notifying the corporation and identifying himself or herself as well as the common ancestor and designating the tax year in which the election takes effect. common ancestor cannot be more than six generations removed from the youngest descendant shareholder. spouses and former spouses of the common ancestor or any lineal descendant may also be counted as family members. Also, estates of deceased family members and family members who own stock through certain trusts will not be counted as separate shareholders. LLCs and multipurpose form 2553. A domestic LLC with two or more owners is classified as a partnership under the default rules but may choose to be treated as a corporation by filing form 8832. When corporate status is chosen, the entity may elect S status. In the past, an LLC was required to file form 8832 to elect corporate status and then file form 2553 to elect S status. New regulations simplify the paperwork requirements. An eligible entity that makes a timely and valid election to be classified as an S corporation will be deemed to have elected to be classified as an association taxable as a corporation. When form 2553 is filed by the 15th day of the third month of a taxable year, both the deemed election to be classified as a corporation and the S election are effective as of the first day of that year. …