Chapter 1: Entity Types and Their Formation

CHAPTER 1, CONTENTS: ENTITY TYPES AND FORMATION

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Topic 11: Types

of
Business
Entities

Topic 1-2:
Corporation
Formation and Rules
Encouraging
Investments in
Corporations

Topic 1-3:
Partnership
Formation and
Rules Encouraging
Investments in
Partnerships

Topic 1-4:
Requireme
nts to
Become an
S
corporation

OVERVIEW OF TOPIC 1-4

A.
B.

THE OBJECTIVES OF THIS TOPIC ARE TWOFOLD:

Discuss the unique nature of an S corporation and its
key advantages.
Discuss the tax requirements to become an S
corporation.

WHY IS OBJECTIVE A IMPORTANT?

If you chose to start a new S corporation, you need
to know the benefits of doing so
WHY IS OBJECTIVE B IMPORTANT?
Knowing the tax requirements to become an S corporation
is essential
if you want to operate your business in this form
An outline of the content and organization of Topic 01-4 is as
follows:
Part A: Becoming an S Corporation: In general
I.

The unique nature of S Corporations.

II.

The two methods of becoming an S corporation.

III.

Course assumptions regarding Limited Liability Companies

and S Corporations.

IV.

The key benefits of an S Corporation (Fixed status method

assumed).

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Chapter 1: Entity Types and Their Formation

Part B: S Corporation Elections
I.

S Corporation formation issues

II.

Eligibility requirements for an S Corporations

III.

The S Corporation election requirements.

IV.

Comparison of S Corporation with Limited Liability Company.

V.

Illustration of an Advantage of an S Corporation.

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Chapter 1: Entity Types and Their Formation

PROBLEM TO BE SOLVED
PROBLEM 1-4. Two doctors form Surgical Associates, an S
corporation. Ordinary business income (OBI) of the business in
the current year is $1,200,000. This $1,200,000 ordinary business
income is net of the $120,000 salary paid to each doctor.
Required. What is the benefit of this tax plan?

PART A: BECOMING AN S CORPORATION: IN GENERAL

Text pages 15-5 to 15-6
LO
7
I.

Discuss the unique nature of an S corporation and its key

advantages.
UNIQUE NATURE OF S CORPORATIONS
A. HYBRID ENTITY
The S corporation combines the legal environment of
C corporation with tax treatment similar to (but not
the same as) partnership taxation
A. CONGRESSIONAL INTENT
The S corporation election was enacted to minimize
the influence of taxes in the selection of an entity to
conduct a business

II.

DISCUSS THE TWO METHODS OF BECOMING AN S

CORPORATION
A. AS DISCUSSED EARLIER A LIMITED LIABILITY
COMPANY CAN ELECT TO BE TAXED AS A
CORPORATION UNDER THE CHECK-THE-BOX
REGULATIONS. The two methods of becoming
corporation are diagramed below highlighted in grey
the filing requirements are the state law requirements.
B. ANY CORPORATION CAN THEN ELECT TO BECOME
AN S CORPORATION. Thus, there are two methods of
becoming an S corporation, which are diagramed below
highlighted in light blue:
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Chapter 1: Entity Types and Their Formation

1. Highlighted below (on page 4) is the information
required to be reported on page 1 of Form 2553 (the
S election).

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Chapter 1: Entity Types and Their Formation

FIXED STATUS METHOD

File
articles
of
incorporation with a state
to be a corporation.

File an election (Form

2553) with the Internal
Revenue Service to be taxed
as an S corporation

III.

ELECTIVE STATUS METHOD

File articles of organization with

a state in order to be a Limited
Liability Company.

Then elect to be taxed as a

corporation for Federal income tax
purposes, using check-the-box
election Form 8832.

File an election (Form 2553) with

the Internal Revenue Service to be
taxed as an S corporation

DESCRIBE THE COURSE ASSUMPTIONS REGARDING

LIMITED LIABILITY COMPANIES AND S
CORPORATIONS
A. LIMITED LIABILITY COMPANIES. Future discussion of
LLCs will assume
1. that it has at least two members and
2. that it does not make an election to be taxed as
a corporation.
B. S CORPORATIONS. Future discussion of S corporations
will assume
1. that it has been an S corporation from its
inception and
2. that it became an S corporation by the fixed
status method.

IV.

DESCRIBE THE KEY BENEFITS OF AN S CORPORATION

(FIXED STATUS METHOD ASSUMED).

A. ADVANTAGES.
1. Advantage One. The stock of the S corporation will
be relatively easy to sell.
2. Advantage Two. The S corporation would be
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Chapter 1: Entity Types and Their Formation

eligible to issue Section 1244 stock, providing for
ordinary deduction within limits if the stock becomes
worthless.
3. Advantage Three. The character of the
corporations earnings that are passed-through is
portfolio, not earned (as long as the stockholder
actively participates in the business activities of the
corporation).
4. Advantage Four. The items of income and
deduction are subject to a single level of taxation.

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Chapter 1: Entity Types and Their Formation

Form

2553

Note.

Part I

Election by Small Business Corporation

(Under section 1362 of the Internal Revenue Code)

This election to be an S corporation can be accepted only if all the tests are met under Who May Elect in the
instructions, all shareholders have signed the consent statement, an officer signed below, and the exact name and
address of the corporation (entity) and other required information have been provided.
Election Information
Name of corporation

A Employer Identification number

Number, street, and room or suite

B Date incorporated

City or town, state, and ZIP code

C State of incorporation

D Check the applicable box(es) if the corporation (entity), after applying for the EIN shown in A above changed its

name or

address

E Election to be effective for the tax year beginning (month, day, year) (see instructions). . . . . . . . .
Caution. A corporation (entity) making the election for its first tax year will usually enter the
beginning date of a short tax year that begins other than January 1.
F Select tax year:
(1)
Calendar year
(2)
Fiscal year ending (month and year) ___________________
(3)
52-53 week ending with reference to the month of December.
(4)
52-53 week ending with reference to the month of ___________________
If box (2) or (4) is checked, complete Part II.
G If more than 100 shareholders are listed for item J (see page 2), check this box if treating members of a family as one
Shareholder results in no more than 100 shareholders (see test 2 under Who May Elect in the instructions
H Name and title of officer or legal representative who the IRS may call for more
information

I. Telephone number of officer

or legal representative

If this election is being filed late, I declare that I had reasonable cause for not filing Form 2553 timely, and if this late
election is being made by an entity eligible to elect to be treated as a corporation, I declare that I also had reasonable cause
for not fling en entity classification election timely and that the representations listed in Part IV are true. See below for my
explanation of the reasons the election were not made on time and a declaration of by diligent actions to correct the mistake
upon its discovery (see instructions).

Sign
Here

Under penalties of perjury, I declare that I have examined this election and accompanying documents, and
to the best of my knowledge and belief, the election contains all the relevant facts relating to the election, and
such facts are true, correct, and complete.

Signature of officer

Title

Date
Form 2553

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Chapter 1: Entity Types and Their Formation

PART B: S CORPORATION ELECTIONS
Text pages 22-2 to 22-4
LO
8
I.

Discuss the requirements to become an S corporation.

DESCRIBE THE S CORPORATIONS FORMATION
ISSUES.
A. SECTION 351 STATUTORY REQUIREMENTS. In
general C and S corporations are subject to the same
statutory requirements for formation.
The key requirement for tax-free formation of
corporations is that the shareholders must be in
control, which is defined as 80% or more stock
ownership.

II.

DESCRIBE THE ELIGIBILITY REQUIREMENTS FOR AN

S CORPORATION
A. CORPORATE ELIGIBILITY REQUIREMENTS
1. Corporation must be a domestic corporation
2. Certain banks and insurance companies are
ineligible.
B. CORPORATE STOCK REQUIREMENTS
1. The corporation can have only one class of stock
with respect to distribution (or liquidation)
rights.
2. The corporation may have stock with differences
in voting rights.
C. SHAREHOLDER REQUIREMENTS
1. Maximum number of shareholders. Must have
100 or less shareholders (Husband and wife are
considered one shareholder)
2. Type of Shareholders. Primarily shareholders
must be individuals who are:
a. U.S. citizens or
b. resident aliens

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Chapter 1: Entity Types and Their Formation

D. THESE ELIBILITY REQUIREMENTS must be satisfied at
the time of election and at all times thereafter.

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Chapter 1: Entity Types and Their Formation

III.

DESCRIBE THE S CORPORATION ELECTION

REQUIREMENTS
A. THREE REQUIREMENTS FOR A VALID S ELECTION
1. The election must be timely filed
2. All shareholders must consent to the election
3. The corporation must meet the eligibility
requirements at the time of election and
thereafter.
B. REQUIREMENTS FOR EFFECTIVENESS IN THE YEAR
FILED.
1. To be effective for the current year, the election
must be filed by 15th day of third month of
current tax year, or have a reasonable cause for
not filing Form 2553 timely, which is accepted
by the IRS.
2. Elections filed after the 15th day of third month of
current tax year are effective for the next year;
unless the I.R.S. approves otherwise.
C. FORMS 1120S AND 2553 INFORMANTION.
1. Highlighted below is the S election information
required to be reported each tax year.

Form

1120S

U.S. Income Tax Income for an S Corporation

For calendar year 2014 or the year begin_____, and end_____

2014

A S election effective date

Name of corporation

D Employer Id number

B. Business activity code

number (see instructions)

Number, street, and room or suite

E Date incorporated

City or town, state, and ZIP code

F Total assets (see instr)

C.

Check if Sch M-3 attached

G.

Is the corporation electing to be an S corporation beginning with this year?

Check if (1)

Final rtrn (2)

Name change (3)

Yes

Address change (4)

No

If yes attach Form 2553 if not already filed .

Amended rtrn (5)

S election termination or revocation

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Chapter 1: Entity Types and Their Formation

IV.

COMPARISON OF S CORPORATION WITH LIMITED

LIABILITY COMPANY

A. KEY BENEFITS OF A LIMITED LIBILITY COMPAPNY.

The following are some key partnership advantages.
1. Advantage One. The owners of a LLC can include
entity liabilities in their outside basis.
2. Advantage Two. The owners and entity have
flexibility in altering the allocation of income
and losses by changing partnership the profit and
loss ratios.
3. Advantage Three. The LLC will be treated as a
partnership for state law purposes thereby avoiding
state corporate income taxation and/or franchise
taxation.
4. Advantage Four. The items of income and
deduction are subject to a single level of taxation.
B. IN SUM. The tax professional must weigh the benefits of
an S corporation against the benefits of a Limited
Liability Company is deciding which method to
recommend to a client.
S CORPORATION VERSUS A LIMITED LIABILITY COMPANY
Advantages are
highlighted
Transferability of
ownership interest

S Corporation

LLC

Stock is relatively
easy to sell.

Ordinary loss available

if entity fails.
Includibility of entity
liabilities is owners
outside basis
Flexibility in altering
the allo-cation of
income and losses
Character of earnings
that

Yes if Section 1244

stock is issued.
Not available

A partnership
interest is more
difficult to sell
Not available

No. Must be
allocated by % of
stock ownership
Portfolionot
subject to self-

Yes
Yes by changing
partner-ship
profit & loss ratios
Earned subject to
self-employment

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Chapter 1: Entity Types and Their Formation

are passed-through.
Subject to state income
taxation.
Subject to a single level
of federal taxation

employment tax
Corporations are
often subject to
such taxation
Yes

tax.
LLCs are generally
not subject to such
taxation
Yes

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Chapter 1: Entity Types and Their Formation

VI.

ILLUSTRATION OF AN ADVANTAGE OF S
CORPORATION ELECTION (PROBLEM 1-4)
A. KEY FACTOR. The business generates large profits and
the shareholder-employees desire to avoid Medicare
taxes.
1. A unique feature of pass through of S corporation
ordinary business income is that it is
considered portfolio income, which is not subject
to self-employment tax
2. In order for OBI to be considered portfolio,
shareholder-employees must pay themselves a
reasonable salary; i.e., it cannot be unreasonably
low.
3. Tax professionals recommend that the amount of
salary be at least equal to the social security
maximum wage base.
2014 FICA Tax System
Maximum
Employee
Wage
Tax Rate
Max. Tax
Base

Social
Security
Medicare
TOTALS

$117,000
Earned
Inc.

6.20%
1.45%

$7,049.40
No Max.

7.65%

Self Employed
Tax
Max. Tax
Rate
$14,098.8
12.40%
0
2.90%*
No Max.
15.30%

This table will change every year because the Social Security maximum wage base is
indexed to the CPI.

* Wealthy individuals (e.g. a married couple filing jointly with AGI

in excess of $250,000) are required to pay an additional 0.9%
Medicare tax.
Problem 1-4Brief Summary of Facts.
1. The ordinary business income (OBI) of Surgical Associates is
$1,200,000
2. Each shareholder-employee doctor received a salary of
$120,000, which is considered reasonable.
Analysis of Problem 1-4. Two things should be clear by now:
What are the tax consequences of this?
The OBI of Surgical Associates is portfolio income
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Chapter 1: Entity Types and Their Formation

What are the tax savings implications?
The tax savings from this plan is the avoidance of Medicare
tax
Assuming each doctor owns 50% of the stock determine the
amount of tax savings for each doctor.
Start: Prorata share OBI for each doctor
Times: Times Medicare rate (2.9% + 0.9% =
3.8%)
Equals Tax savings
:

$600,000
3.8%
$ 22,800

TOPIC 1-4: CONCEPT QUESTIONS

1.12 Which of the following is not a requirement to become an
S corporation?
A.
Corporation must be a domestic corporation
B.
The corporation can have only one class of stock
C.
The stock must have the same voting rights
D. Number of shareholders cannot exceed 100
E.
Shareholders must be individuals who are U.S. citizens
or resident aliens
Answer to Question C.
1.12
1.13 Which of the following is not a requirement for a valid S
election?
A.
The election must be timely filed
B.
All shareholders must consent to the election
C.
The corporation must meet the eligibility requirements
at the time of election.
D. The corporation must continuously meet the eligibility
requirements after the initial election.
E.
None, they are all required
Answer to Question E.
1.13
1.14 Which of the following is a key advantage of becoming an S
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Chapter 1: Entity Types and Their Formation

corporation (fixed status method assumed)?
A.
The ownership interest is relatively easy to sell.
B.
The character of income with material participation is
portfolio, not earned.
C.
Ability for owner to have ordinary loss if the entity
fails.
D. All of the above
Answer to Question D
1.14

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Chapter 1: Entity Types and Their Formation

TOPIC 1-4:
REQUIREMENTS TO BECOME AN S CORPORATION
LEARNING EXPECTATIONS
Now that Topic 1-4 is complete you should be able to
A.

Discuss the two methods of becoming

corporation and our course assumptions.

an

1. Discuss the unique nature of S corporations.

2. Describe the two methods of becoming an S
Corporation.
3. Describe the course assumptions regarding Limited
Liability Companies and S Corporations.
B.

Discuss the requirements to become an S corporation.

1.

Describe the S corporation formation issues.

2.

Describe the eligibility requirements for an S

corporation.

3.

Describe the S corporation election requirements.

4.

Describe the key benefits of an S Corporation (fixed

status method assumed).

5.

Explain the illustration of one of the key features of an S

Corporation indicating the advantage of making an S election.
We have completed the contents of Chapter 1 and are ready to
move on to Chapter 2.

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