Electing and Unwinding an S Corporation

Two detailed examples review the opportunities and pitfalls

The S corporation is one the most common vehicles for taxpayers to conduct a business; however, many taxpayers (or their tax professionals) elect S corporation treatment without doing a proper analysis, and it is suboptimal for their situation.

Using two examples, this article will review how to elect S corporation status for an eligible entity, followed by the two ways to undo that status if it is later unwanted.

Example 1 - Kira

Kira formed her LLC on September 1, 2023. Since she is the sole owner of the LLC, it is a disregarded entity under the entity classification regulations. When an entity is disregarded, the owner reports the LLC’s tax attributes on the owner’s tax return based on the character of the activity that generates those attributes. For example, if the LLC holds stocks for investment, the dividends are reported on Form 1040, Schedule B, and the sales on Form 1040, Schedule D.

Kira has until November 15, 2023 to timely elect S corporation status with an effective date of September 1, 2023. See §1362(b)(1)(B). Kira files Form 2553, Election by a Small Business Corporation, to elect S corporation status. By filing Form 2553, Kira is making two elections simultaneously: an election to be taxed as a corporation, followed by an election by the corporation for S corporation status. Kira does not file Form 8832, Entity Classification Election. See Internal Revenue Manual (IRM) 3.13.2.27.1(2) (01-01-2024), Entities Eligible to File Form 8832, and Treas. Reg. §301.7701-3(c)(1)(v)(C):

An eligible entity that timely elects to be an S corporation under section 1362(a)(1) is treated as having made an election under this section to be classified as an association, provided that (as of the effective date of the election under section 1362(a)(1)) the entity meets all other requirements to qualify as a small business corporation under section 1361(b). Subject to §301.7701–3(c)(1)(iv), the deemed election to be classified as an association will apply as of the effective date of the S corporation election and will remain in effect until the entity makes a valid election, under §301.7701–3(c)(1)(i), to be classified as other than an association.

On the effective date of the election, September 1, 2023, Kira was deemed to transfer all of the assets and liabilities of the LLC in exchange for the stock in the newly elected S corporation; this was a §351 tax-deferred exchange since Kira owned 100% of the stock in the S corporation afterwards. See Treas. Reg. §301.7701-3(g)(1)(iv).

Fast forward to February 2024: Kira asked her trusted tax advisor about forming the LLC or electing S corporation treatment. Since Kira only anticipates $20,000 of net income going forward and failed to pay herself wages for 2023, her tax advisor recommends reverting the LLC to a disregarded entity. The best way for Kira to do this is to withdraw the underlying corporation election.

IRM 3.13.2.27.10 (01-01-2024), Request to Withdraw Classification Election, outlines the process to withdraw an entity classification election:

Correspondence or a new Form 8832 may be received indicating the taxpayer wants to withdraw/rescind their entity classification election…

For the taxpayer to withdraw/rescind the election, the request must be received by the due date of the initial tax return. A withdrawal/rescission is a request to treat the entity as if the classification election had never been input or applied…

If we allow the entity to return to the default classification and the entity is no longer classified as an association taxable as a corporation and there is a Subchapter S-election on file, the Subchapter S-election terminates.

Kira should file Form 8832 or submit a withdrawal statement to the IRS so that it is received by March 15, 2024; if she does this, it will be as if the LLC never made any entity classification elections, and the LLC will be a disregarded entity for 2023.

Example 2 - Dwayne and Paul

Dwayne and Paul are married in Washington, a community property state. On July 1, 2021, Dwayne formed an LLC, of which he is the sole owner; however, the LLC is held as community property under Washington law.

Under Rev. Proc. 2002-69, an LLC held as community property can be treated as either a disregarded entity or a partnership; how it is treated is at the spouses' discretion, and no elections are required. This is NOT a qualified joint venture under §761(f), as LLCs are ineligible for this election.

For tax year 2021, they treated it as a disregarded entity. Dwayne reported the business activity on a single Schedule C since he was the only one who participated in the business activity. See 2023 Schedule C Instructions, p. C-3.

The LLC filed Form 2553 and elected S corporation status effective January 1, 2022, and it filed S corporation returns for tax years 2022 and 2023. In early March 2024, Dwayne told his tax advisor he no longer wanted to run payroll or file S corporation tax returns, so he wanted to convert the LLC back to a disregarded entity.

Dwayne cannot convert the LLC to a disregarded entity until January 2027. Once an entity classification election is made for an eligible entity, it cannot make another election during the 60-month period after the effective date of the election. See Treas. Reg. §301.7701-3(c)(1)(iv).

There are two exceptions to this rule:

1. The 60-month limitation does not apply to a newly formed eligible entity that makes an entity classification election effective on its formation date.

2. The IRS may permit it via private letter ruling if more than 50% of the ownership interests are owned by persons with no ownership interest in the entity on the prior election's effective date or filing date.

If the LLC had made its S corporation election effective on July 1, 2021, the LLC could convert to a disregarded entity effective on January 1, 2024 under the first exception listed above. There is usually a two-step process to convert the LLC in this situation:

1. Revoke the S election by sending a letter to the IRS on or before March 15, 2024, with an effective date of January 1, 2024. See IRM 3.13.2.23.15 (03-08-2023), Revocation of an S-Election, for the required procedure.

2. Elect disregarded entity treatment by filing Form 8832 on or before March 15, 2024, with an effective date of January 1, 2024.

However, IRM 3.13.2.23.17 (03-08-2023), Termination of S-Election, states that:

If an LLC made a Subchapter S-election and then chooses to convert or reorganize to their initial classification, their S-election terminates.

This implies that the LLC only needs to file Form 8832 to elect disregarded entity treatment and that the S election will automatically terminate without requiring a separate revocation statement.

The conversion back to a disregarded entity is deemed liquidation of the corporation and is a taxable event to the shareholder under Treas. Reg. §301.7701-3(g)(1)(iii). The instructions to Form 966, Corporate Dissolution or Liquidation, state that form is not required when there is a deemed liquidation under the entity classification regulations.

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