S Corporations From Formation to Termination

An S corporation is a special type of corporation that elects to pass corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes, avoiding the double taxation that applies to C corporations. To qualify for S corporation status, a business must meet several IRS requirements: it must be a domestic corporation, have only allowable shareholders (which include individuals, certain trusts, and estates but not partnerships, corporations, or non-resident alien shareholders), have no more than 100 shareholders, have only one class of stock, and not be an ineligible corporation type such as certain financial institutions, insurance companies, or domestic international sales corporations. To elect S corporation status, the corporation must file Form 2553 with the IRS, signed by all shareholders. The election must generally be made by March 15 of the tax year for which it is to be effective, or any time during the preceding tax year. Late elections may be accepted with reasonable cause. S corporations combine the liability protection of a corporation with the pass-through tax treatment of a partnership, making them a popular structure for closely held small and medium-sized businesses.

S corporations are pass-through entities for federal income tax purposes, meaning the corporation itself generally does not pay federal income tax. Instead, income, losses, deductions, and credits flow through to shareholders in proportion to their ownership percentage and are reported on each shareholder's individual tax return. Shareholders must pay income tax on their allocated share of S corporation income whether or not the corporation actually distributes the money to them. This can create cash flow challenges for shareholders who owe tax on undistributed earnings. S corporation losses can also pass through to shareholders, but are limited to each shareholder's stock and debt basis in the corporation — losses exceeding basis are suspended until basis is restored by future income or additional contributions. Shareholders who are active in the business may be subject to self-employment tax rules, though the S corporation structure provides a potential advantage: only wages paid to shareholder-employees are subject to payroll taxes, while distributions of profit above reasonable compensation are not. This distinction makes reasonable compensation determinations a key area of IRS scrutiny for S corporations.

While S corporations generally avoid entity-level federal income tax, there are several special tax situations that can result in the corporation itself owing tax. The built-in gains (BIG) tax applies to S corporations that converted from C corporation status if they dispose of appreciated assets that were held at the time of the S election within the recognition period (generally 5 years). The BIG tax is assessed at the highest corporate rate on the net unrealized built-in gain recognized during the recognition period, and is designed to prevent C corporations from avoiding corporate tax by electing S status just before selling appreciated assets. The excess net passive income tax applies to S corporations with accumulated earnings and profits from prior C corporation years if more than 25% of gross receipts are passive income. Additionally, some states do not recognize S corporation status or impose their own entity-level taxes on S corporations, so state tax treatment varies significantly. These special tax provisions can create unexpected corporate-level tax liabilities that shareholders and their advisors must anticipate, particularly in conversion scenarios or when a significant portion of the corporation's income is passive.

An S corporation election can be terminated voluntarily or involuntarily, and the consequences can be significant. Voluntary termination occurs when shareholders holding more than 50% of the outstanding stock consent to revoke the election. Involuntary termination occurs when the corporation ceases to meet S corporation eligibility requirements — for example, by exceeding the 100-shareholder limit, issuing a second class of stock, transferring shares to an ineligible shareholder such as a nonresident alien or a C corporation, or receiving an excessive amount of passive income for three consecutive tax years while having accumulated C corporation earnings and profits. When an S election terminates, the corporation reverts to C corporation status for tax purposes starting on the day of the terminating event. The short S corporation tax year ending on that date and the C corporation year beginning on the same date each require separate tax returns. After an involuntary termination, the corporation generally cannot re-elect S status for five years without IRS consent. Shareholders and tax advisors must monitor S eligibility continuously to avoid unintended terminations that could trigger significant and unexpected tax consequences.

Both S corporations and LLCs taxed as partnerships offer pass-through taxation and liability protection, but they differ in several important ways that affect which structure is preferable for a given business. S corporations have stricter ownership rules — limited to 100 shareholders who must be US citizens or residents, with only one class of stock allowed — while LLCs have no restrictions on the number, type, or nationality of members and can have multiple classes of membership interest with different economic rights. S corporations must pay shareholder-employees reasonable compensation subject to payroll taxes, creating both compliance obligations and tax planning opportunities; LLC members in a partnership-taxed LLC generally pay self-employment taxes on their distributive share of business income. S corporations file Form 1120-S and issue Schedule K-1s to shareholders; LLCs taxed as partnerships file Form 1065 and issue Schedule K-1s to members. LLCs offer more flexibility in allocating income and losses among members through special allocations, which are not permitted in S corporations due to the single class of stock rule. For businesses seeking maximum structural flexibility or those with foreign investors, the LLC structure is often preferable; for businesses seeking to minimize self-employment taxes, the S corporation may offer an advantage.