A very common and costly mistake is when people hear something about a tax strategy and then think they can set everything up on their own, without the services of a professional advisor.  This is a perfect example of the “penny wise pound foolish” adage.  Over the past few weeks, I had some interesting email exchanges with readers who found themselves in the deep water after setting up S corps on their own.  Here is one of them.

From a Reader:

Subject: S-Corp question

Hi Kerry,

 

I wondered if you could kindly answer a question for me. I’ve tried and tried to find the answer online to my exact situation, but I still feel confused.I am self-employed and I run a small business from home for 3+ years now. During the year I make quarterly payments on my federal taxes with vouchers. Then I simply file a 1040 under my name and SS number, and include the name of my business on my schedule c. Real simple.  

 

Well last year I stupidly got talked into becoming an S-corp (which isn’t even necessary for my small biz) and I got the approved S-corp election in the mail. It says it went into effect starting in May 2013. I never did anything with it and now want to just continue to file my usual 1040 and schedule c (sole proprietorship). I am the only owner of the business. I have no employees etc.. what do I do with this open S-corp status which I have never used or filed under? Also, as additional information, I did make my usual quarterly payments during 2013. I just need to know how to file as usual come April without going the S-corp route? How do I get rid of this S-corp status?

 

Thank you in advance,

My reply:

Before I can advise, I need some more info.

In order to file for an S election with IRS, you must have set up a new corporation or LLC.  A Schedule C isn’t eligible for the S election.

Please tell me what entity you filed the S election for and in what State.

Kerry Kerstetter

Reader:

Hi Kerry,

It was my already existing business which is a title searching company. As far as the schedule C is concerned I meant that this is a schedule I have been using each year along with my 1040, because I was just filing personal taxes. 

The s-corp was approved in may 2013 but I have never filed any returns as an SCorp, nor do I want to. I want to just terminate the SCorp status and continue to file as I have been all these years, as sole proprietorship under my ss#.

Thanks,

Oh and Florida is the state

KMK:

If I understand you correctly, you filed the S election (Form 2553) for your sole proprietorship (Schedule C) business.  That is not legally allowed and was an improper filing. The S election is only to be used for corporations or LLCs.

I am trying to figure out why you did that.  You may have mistakenly assumed that you were forming a new corporations by filing the 2553 with the IRS.  That is not how corporations are established.  Every corporation is chartered by the state in which it is to be headquartered, such as Florida in your case, by the Secretary of State’s office.  After the corp is born (chartered), an election can then be made with IRS to be taxed as an S corp.  This can only be done with existing corporations.  IRS has never chartered or established new corporations

Since the 2553 filing was improper (illegal), the S election was as well.  You shouldn’t have to do anything formally to revoke an election that wasn’t legal to start with.  If IRS does send a letter asking where your 1120S is, write back and explain your mistake in improperly filing the 2553.

This is a perfect illustration of why it is so dangerous for small business owners to try to handle tax matters on their own.  You should be working with an experienced professional tax advisor before doing anything that would affect your taxes, such as changing the tax entity.  Any tax pro would have told you that an S election isn’t legally possible for a sole proprietorship.

Good luck.  I hope this info helps.

Kerry

Reader:

Kerry,

Well I went from a DBA to an LLC to an SCorp. The LLC and SCorp transition took place at the same time. I did it on line.

I made the transition because I was told by my tax person

At that time that I could save money if I became an SCorp.

I have not yet filed taxes as an SCorp and I don’t want to. I’m simply

Trying to find out if I can cancel the whole LLC-SCorp and file as a DBA for 2013 , like I have been all these years. 

I don’t know how else to word my question. I made a mistake. I should not have done the SCorp route…

Thank you,

KMK:

Thanks for the additional info.  What I am going to say is based on the info you have provided and should be verified by a professional tax advisor who can look at the actual paperwork you have regarding the LLC and S-Corp with both IRS and the State of Florida.  There may be another wrinkle to this that you don’t see.

If the paperwork checks out, it looks like you can probably just ignore the S election with IRS and continue to file your business activity on Schedule C with your 1040.  IRS may send you a letter asking where your 1120S is for the S corp.  You can simply respond that the election was done in error.

If your business is profitable, IRS has no motivation to force you to use the 1120S because the Schedule C almost certainly results in more tax revenue for them, especially considering the SE tax that would be avoided with an S corp.

You also need to check with the Florida Dept of State regarding officially dissolving the corp so that they don’t come after you later on for unpaid annual report fees and penalties.  You can do this online at their website:
https://efile.sunbiz.org/dissolve01.html

I hope this helps.  Again, you should start working with a professional tax advisor ASAP who can assist you in a more timely manner in matters such as this.

Good luck.

Kerry

Final from Reader:

Kerry,

Thank you so much for your help. I was also doing some research and pretty much came to the same conclusion. And yes Realize I have to dissolve the corp with the Florida dept of state and started researching this too. Thank you for the link you sent below. 

Again I appreciate your time and your excellent suggestions!

Best,

Q:

Subject: S Corporation

Hello, I was doing some research on S corporations and came across your website through a Google search. You noted several times that a disadvantage of electing S corp status is that you must use a calendar year-end. Can you please provide a reference citing this requirement? IRS Form 2553 specifically allows the corporation to select a tax year, whether it be calendar year or fiscal year, so I’m curious to see what you are referencing.

Regards,

A:

Until the mid-1980s, an S corp was allowed to have a fiscal year ending at the end of any month, just as with C corps.  Then there was a new law or regulation passed that required all S corps to switch to a December 31 tax year.  I can remember having to do a lot of short year 1120S returns to make this transition for clients’ S corps.

Basically, the reason for the requirement was to keep the S corp tax year in sync with the tax year of its owners.  If a majority of the owners have a different tax year, that is justification for using a similar tax year for their S corp. Since almost all individuals have a calendar tax year, S corps they own are required to use that same tax year.

Here is The Code section dealing with this:

§ 1378(a) General rule
For purposes of this subtitle, the taxable year of an S corporation shall be a permitted year.

§ 1378(b) Permitted year defined
For purposes of this section, the term “permitted year” means a taxable year which—

§ 1378(b)(1) is a year ending December 31, or

§ 1378(b)(2) is any other accounting period for which the corporation establishes a business purpose to the satisfaction of the Secretary.

For purposes of paragraph (2), any deferral of income to shareholders shall not be treated as a business purpose.

Here is the applicable section on Page 1 of the instructions for Form 2553:

7. It has or will adopt or change to one of the following
tax years.
a. A tax year ending December 31.
b. A natural business year.
c. An ownership tax year.
d. A tax year elected under section 444.
e. A 52-53-week tax year ending with reference to a year
listed above.
f. Any other tax year (including a 52-53-week tax year)
for which the corporation establishes a business purpose.

While they do mention using a different year, in practical application, this is rarely granted by IRS except in cases where the shareholders also have a non-calendar tax year.  When the S corp has a different tax year than its owners, it makes it more complicated for IRS to match things up between them, which is why they don’t like it.

If you feel you have a good case for using a non calendar tax year for your S corp, you can try to convince IRS to allow it.  I seriously doubt it will be granted; but I would be interested in hearing about your results with this request.

I hope this helps you understand the rules regarding S corp tax years.

Good luck

Kerry Kerstetter

Q:

Subject: a question about converting s corp to c corp

Hello Kerry,

I read your article on converting s corp to c corp and you said when converted, the c corp cannot be changed back to s corp for at least 5 years. I’m wondering if you have official IRS documents supporting that 5-year restriction. We have a client that converted to c corp from s corp in 2009 and now wants to switch back to s corp. I told my boss we cannot do that but she affirmatively said there is a way to reverse the revocation, which I didn’t find. If you can show me the official publication about the cannot change back for 5 years restriction, I can show it to her. The link of your article is: http://www.taxguru.org/corps/scorp.htm Thanks for all your help! Have a great weekend!

Best,

A:

That five year waiting period has been around a long time.  Here is the relevant info from Page 19-6 of the latest edition of TheTaxBook:

Five-Year Waiting Period for Reinstatement

If an S corporation election is terminated, whether
by shareholder revocation, ceasing to qualify, or
violating the passive income restrictions, a five-
year waiting period applies during which the
corporation cannot re-elect S corporation status
without IRS consent. [IRC §1362(g)]

From the IRC:

§ 1362(g) Election after termination

If a small business corporation has made an election under subsection (a) and if such election has been terminated under subsection (d), such corporation (and any successor corporation) shall not be eligible to make an election under subsection (a) for any taxable year before its 5th taxable year which begins after the 1st taxable year for which such termination is effective, unless the Secretary consents to such election.

As I constantly advise, it is generally easier to just charter a brand new corp than to mess around with converting from C to S or vice versa.

I hope this helps.

Kerry Kerstetter

Follow-Up:

Dear Kerry,
 
Thanks for you immediate response and sorry for writing back to you so late.  I think my boss is determined to go around that 5 year waiting period and I’ll be writing to the Secretary for consent. I’ll let you know how that goes.
 
Best,