Filing a timely S election

The deadline for filing Form 2553, Election by a Small Business Corporation, differs depending on whether the corporation is already in existence (i.e., operating as a C corporation) or newly formed.

When a C corporation elects to become an S corporation, S status begins on the day following the last day of the electing C corporation's tax year. For an existing C corporation that is converting to S status, the S election may be filed:

1. During the year preceding the first tax year the S election is to be effective; or
2. On or before the 15th day of the third month of the initial S corporation year (Sec. 1362(b)(1); Regs. Sec. 1.1362-6(a)(2)(ii)).

Thus, the S election can be retroactive to the first day of the tax year if the election is filed within 2½months after the beginning of the tax year. However, the S election is retroactive to the first day of the tax year only if the electing corporation qualifies as a small business corporation on the first day of the tax year and on each day until the election is filed (Regs. Sec. 1.1362-6(a)(2)).

Example 1. Determining when the election becomes effective when C corporation elects S status: An existing calendar-year C corporation decides to elect S status effective for its tax year beginning on Jan. 1, 2019. The election must be made during 2018 or on or before March 15, 2019. An election filed on March 20, 2019, for example, cannot be effective retroactively and would be effective for the tax year beginning on Jan. 1, 2020.

For a newly formed corporation, the election must be filed on or before the 15th day of the third month of the first tax year. An S corporation's initial tax year does not begin until the earliest to occur of the following three events: the corporation has shareholders, acquires assets, or begins doing business. The term "month" is defined as the period starting on the day within the calendar month that is numerically equal to the first day of the tax year and ending on the day before the same numerical day in the next calendar month (Regs. Sec. 1.1362-6(a)(2)(ii)(C)). Since most newly formed corporations do not begin their first tax year on the first day of a calendar month, the election deadline may not fall on the 15th of a given month.

Example 2. Determining when the election becomes effective when a newly formed corporation elects S status: A newly formed corporation begins business on June 15, 2018, and decides to immediately elect S status. For the election timing rule, the company's first month ends on July 14, and the company's second month ends on Aug. 14. Therefore, the 15th day of the third month falls on Aug. 29, 2018, which is the deadline for the company to file its S election.

When newly formed corporation comes into existence

The S election should not be filed prior to corporate formation. The courts have held that an S election is not valid if the corporation is not in existence at the time the election is filed (Frentz, 44 T.C. 485 (1965), aff'd 375 F.2d 662 (6th Cir. 1967); Ratcliff, T.C. Memo. 1980-12). Similarly, IRS regulations state that an election made earlier than the beginning of the first tax year will not be valid (Regs. Sec. 1.1362-6(a)(2)(iii), Example 1).

But when does a newly formed corporation come into existence? The regulations indicate the S election period begins at the earliest date the corporation has shareholders, acquires assets, or begins conducting business (Regs. Sec. 1.1362-6(a)(2)(ii)(C)). This date is considered the first day of a new corporation's initial tax year. Reference to the earliest of these three events also appears on Form 2553. When an election takes effect for the first year of corporate existence, the earliest of these three dates must be disclosed on the election form.

Practitioners will generally find that the earliest of these three dates is triggered by the legal incorporation process (the filing or registration date of the articles of incorporation with the secretary of state). At this point, even though the shares of stock may not actually have been issued, the corporation may be deemed to have shareholders and, therefore, be considered to have satisfied one of the three tests. (See Rev. Rul. 72-257, in which stock subscribers were treated as shareholders from the date of incorporation. This interpretation was also applied in Bone, 52 T.C. 913 (1969).) An S election should not be filed prior to the date on which the business is incorporated, because the business lacks legal corporate existence prior to that date. This is true even if the entity conducts business prior to the date of incorporation. In such circumstances, the practitioner should file a proprietorship or partnership return, as appropriate, to report any business activity up to the date of incorporation.

Example 3. Ensuring that the S election is filed after the entity has properly incorporated: The shareholders mail Form 2553 to the IRS on March 2. However, they do not file the articles of incorporation with the secretary of state until March 14 (which under state law in the state of incorporation is the date the corporate existence begins and the corporation has shareholders). In this situation, the S election is invalid. To ensure that the S election is valid, the Form 2553 should be mailed only after the entity has incorporated under state law.

Example 4. Ensuring that the S election is filed after the beginning of the corporation's first tax year: The shareholders file the articles of incorporation with the secretary of state on March 2 and mail Form 2553 to the IRS the next day. However, the corporation does not have shareholders until March 14 and does not acquire assets and begin transacting business until March 25. Although filed after the date of incorporation, the S election is invalid because it was filed before March 14, the beginning of the corporation's first tax year. (In some states, the filing of articles of incorporation with the secretary of state begins the corporate existence, with the stock subscribers deemed to be shareholders as of that date, even though the corporate stock has not actually been issued.)

Planning tip: If the Form 2553 has been filed before the beginning of the S corporation's first tax year, the planner can make recommendations to correct the error, as illustrated in the following example.

Example 5. Correcting an invalid election filed before the beginning of the S corporation's first tax year: Assume the same facts as in Example 3. On May 1, the client brings the incorporation documentation into the planner's office and the planner discovers that the Form 2553 is invalid. The proper beginning of the tax year is March 14. The 2½ month period beginning on that date ends on May 29 (see Example 2). The planner recommends that a new Form 2553 be submitted on or before May 29 showing an effective date of March 14. The new form should be completely filled out and include all of the required shareholder consents. A letter explaining that the first form was prematurely submitted is attached to the Form 2553. If the error is discovered after the 2½-month period has expired, the corporation can request relief from the invalid election.

Timing of the S election when a corporation is formed but not activated

The practitioner should also recognize that there may be circumstances when a corporation is formed but not activated immediately. In this situation, the S election should not be filed because the 2½-month election period does not start until the corporation has shareholders, acquires assets, or begins doing business, whichever occurs first. For example, an attorney may create a corporation for a client, possibly listing the attorney as the incorporator. When the client is ready to proceed, shares will be issued, assets acquired, etc., at which point the measuring of the 2½-month election period begins. (In some states the corporation is deemed to have shareholders when the articles of incorporation are filed — see above.) However, a person who is considered to be a shareholder under state law solely because he or she is an incorporator is not required to consent to the S election (Regs. Sec. 1.1362-6(b)(3)(i)).

If the initial tax year of a corporation is less than 2½ months, an election made before the 16th day of the third month after the first day of the tax year can be effective for the short tax year (Sec. 1362(b)(4); Regs. Sec. 1.1362-6(a)(2)(ii)). The period within which the election must be made is never shorter than 2½ months.

Example 6. Taking advantage of potential S election effective dates: A newly formed entity was incorporated on Nov. 1, 2018, and will be filing its corporate tax return with Dec. 31 as its tax year end. If the shareholders intend to elect S status for the first short-year return, by when must the election be filed?

Shareholders have great flexibility in this situation. An S election filed between Jan. 1 and Jan. 15, 2019, could specify an effective date of (1) Nov. 1, 2018 (the corporation would be an S corporation for its first short year and thereafter); (2) Jan. 1, 2019 (the corporation would be a C corporation from Nov. 1 through Dec. 31, 2018, and an S corporation thereafter); or (3) Jan. 1, 2020 (the corporation would be a C corporation for the short year ending Dec. 31, 2018, and the 2019 calendar year, and an S corporation thereafter). The shareholders may wish to retain flexibility on this decision by not electing until early January to determine if the actual November and December 2018 operating results of the corporation are best reported under C or S status.

If the corporation opts for either the second or third alternative, it will be a C corporation for a short time before the S election becomes effective. In that event, the S corporation will be subject to the built-in gains tax, and the effects of that tax must be considered in deciding when S status should begin.

The S election is made by filing Form 2553. The election form should be prepared, and shareholder consents should be obtained, as soon as possible after deciding to elect S status. This helps to avoid the possibility that:

1. A shareholder cannot be located or contacted in time to consent to the election;
2. A shareholder changes his or her mind and decides not to elect S status;
3. A shareholder sells or otherwise transfers the S stock to an ineligible (or unwilling) S shareholder; or
4. A shareholder's personal status unexpectedly changes (e.g., the shareholder divorces or becomes physically or mentally incapacitated).

Form 2553 must be signed by a person authorized to sign the corporation's tax returns. The form must also include the name of each shareholder, the number of shares owned and the dates acquired, the shareholders' Social Security numbers, and the shareholders' tax year ends (month and day). Signatures on an S election form are required from two sources: (1) from an officer on behalf of the corporation and (2) from each shareholder consenting to the corporate election. The S election (Form 2553) can be filed by mail, private delivery service, or fax.

Planning tip: Proof of filing the form can be obtained only by properly (1) mailing it by certified or registered mail, or (2) sending it by a designated private delivery service. If the form is mailed, it should be sent by either certified or registered mail, with a return receipt, to provide proof that the form was timely filed. If an approved private delivery service is used, a copy of the receipt showing the date and time of the pickup should be retained.   

This case study has been adapted from PPC's Tax Planning Guide: S Corporations, 32nd edition (March 2018), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).