Key Takeaways

  • A Subchapter S Corporation (or S corp) is a tax designation under the Internal Revenue Code that allows corporations to pass corporate income, deductions, and credits through to shareholders to avoid double taxation.
  • S corps combine the limited liability protection of corporations with pass-through taxation, similar to partnerships or LLCs.
  • To qualify, a business must meet IRS eligibility rules—such as a limit on shareholders and stock class restrictions.
  • While S corps provide potential tax savings on self-employment taxes, they also involve stricter filing, ownership, and operational requirements than LLCs.
  • Electing S corp status requires filing Form 2553 with the IRS within specific deadlines.
  • State-level rules may differ, as some states do not automatically recognize S corp status and require additional filings.

What Is a Subchapter S Corporation?

A chapter S corp, also called a Subchapter S corporation, is a corporate tax status that provides limited liability protection and pass-through taxation. These benefits make the S corporation a popular choice for small business owners. With pass-through taxation, profits and losses are reported on each owner's individual income tax form and are not subject to corporate taxation.'

How Subchapter S Corporations Work

A subchapter S corporation, often called an S corp, is a business entity that elects to be taxed under Subchapter S of the Internal Revenue Code. This election allows the corporation’s income, deductions, and credits to "pass through" to shareholders, who report the income on their personal tax returns. This structure prevents the double taxation that traditional C corporations face—once at the corporate level and again when dividends are distributed.

S corps maintain a separate legal identity from their owners, offering limited liability protection for corporate debts and obligations. Shareholders’ personal assets are generally protected, although they must pay personal taxes on any distributed profits. In addition, S corps can deduct wages, benefits, and certain business expenses, providing flexibility in tax planning.

S corporations are often used by small to mid-sized businesses that want the structure of a corporation but prefer the tax advantages typically associated with partnerships or LLCs

S Corporation Requirements

A corporation that wants to elect S corp tax treatment must meet these requirements:

  • Have 75 or fewer shareholders, with married couples counted as a single shareholder
  • Be owned only by individual shareholders, estates, certain types of trusts and partnerships, charitable organizations that are tax-exempt, and other S corporations provided the other S corp is not the only shareholder

If your S corporation does not have inventory, you can use the cash accounting method in which income is taxed upon receipt and expenses are deducted when they are paid. 

S corporation election must be done before two months and 15 days after the start of the tax year and requires all shareholders to consent in writing. S corporations must use December 31 as the end of the fiscal year.

If you do not maintain the S corporation eligibility conditions or fail to file with the IRS within the allotted time frame, this tax status may be revoked. This means your business will be subject to corporate taxation.

Eligibility Rules for a Subchapter S Corporation

To qualify for Subchapter S Corporation status, a company must comply with IRS regulations outlined in IRC § 1361. These include:

  • Domestic incorporation – The entity must be a U.S. corporation.
  • Shareholder limit – Up to 100 shareholders (the previous limit of 75 was increased by law).
  • Eligible shareholders – Only individuals who are U.S. citizens or residents, certain estates, and qualified trusts may hold shares. Partnerships, corporations, and non-resident aliens cannot be shareholders.
  • Single class of stock – All shares must have identical rights to distributions and voting power; preferred stock is not permitted.
  • Consent requirement – All shareholders must consent in writing to the S corp election.

Certain entities—such as insurance companies, financial institutions using specific accounting methods, and domestic international sales corporations (DISCs)—cannot elect S corp status.

Failure to comply with these rules can cause the IRS to terminate the election, subjecting the company to C corporation taxation.

S Corporation Downsides

Downsides of an S corporation include:

  • Higher legal and tax costs
  • Required annual shareholders and directors meetings and meeting minutes
  • Shareholders must vote on major decisions
  • Only allowed to issue common stock, which can make it difficult to raise capital

Some states allow pass-through taxation for S corporations, while others require corporate income tax, thus subjecting the S corp to double taxation on state income tax. Other states require you to file a specific form for S corp treatment at the state level. Consult a business attorney familiar with the laws of the state where you plan to start your business.

Taxation of Subchapter S Corporations

Although S corporations benefit from pass-through taxation, they must still file an informational tax return (Form 1120-S) each year. The corporation’s income, losses, and deductions flow through to shareholders via Schedule K-1, which they include in their personal tax filings.

Some important tax considerations include:

  • Avoiding double taxation: Income is taxed only at the individual level.
  • Reasonable compensation: Shareholder-employees must receive a fair salary subject to employment taxes. Distributions beyond reasonable compensation may be reclassified by the IRS as wages.
  • State variations: Certain states, such as Illinois, California, and New York, impose additional franchise or state-level corporate taxes even on S corporations.

Additionally, S corporations may face built-in gains taxes if they were previously C corporations and hold appreciated assets when electing S status.

LLC vs. S Corporation

Many business owners are torn between forming an LLC (limited liability company) or an S corp, as both provide pass-through taxation and limited liability protection. While an LLC can have unlimited owners, called members, an S corp is limited to 75 shareholders. Ownership of an LLC is open to non-U.S. citizens, unlike S corporation ownership. Other corporations, trusts, LLCs, and partnerships cannot own shares of an S corporation. While LLCs provide flexible profit distribution, an S corporation can only have one class of stock and distributions must be in accordance with ownership percentages. 

While most states allow an S corp to consist of just one person, some states require at least two people for LLC formations. LLCs have a limited lifespan, while S corps exist in perpetuity. Interests in an S corp can be freely transferred without shareholder approval, while LLC interests require member approval to be sold or transferred.

S corporations offer an advantage over LLCs when it comes to self-employment taxes. Because an S corporation can pay salaries to shareholders who work for the company, their taxable profit is lower even though they must pay 50 percent of each employee's FICA (Social Security and Medicare) taxes.

Benefits of a Subchapter S Corporation

Choosing to become a Subchapter S Corporation provides several potential advantages:

  1. Pass-Through Taxation: Profits and losses pass directly to shareholders, reducing the risk of double taxation.
  2. Self-Employment Tax Savings: Only salaries are subject to employment taxes, while distributions may avoid FICA taxes if compensation is reasonable.
  3. Limited Liability: Shareholders are generally protected from personal liability for business debts.
  4. Credibility and Continuity: Operating as a corporation may enhance credibility with investors and allow perpetual existence regardless of ownership changes.
  5. Tax-Deductible Benefits: Certain employee-shareholder benefits, such as health insurance, may be deductible to the corporation.

However, shareholders must carefully maintain corporate formalities to retain these benefits and avoid IRS scrutiny regarding reasonable compensation.

Filing S Corp Election

An LLC or corporation can elect for S corporation tax treatment by filing IRS Form 2553, Election by a Small Business Corporation. This form requires detailed information to determine whether your business is eligible for this tax status. If you make this election after the 15th day of the third month but before the tax year ends, the election will be in effect for the following tax year. 

How to Maintain Subchapter S Corporation Status

Once the S corporation election is accepted by the IRS, the entity must continue to meet all eligibility and compliance requirements each year to retain its tax status. Common compliance steps include:

  • Holding regular shareholder and director meetings, recording meeting minutes, and maintaining corporate records.
  • Filing annual reports and tax documents on time.
  • Ensuring all shareholders remain eligible persons (no foreign or corporate shareholders).
  • Maintaining only one class of stock.

If any of these rules are violated—for example, if the corporation issues preferred shares or admits an ineligible shareholder—the IRS can revoke S corp status, automatically converting it into a C corporation subject to double taxation.

Frequently Asked Questions

  1. What does “Subchapter S” mean?
    “Subchapter S” refers to a specific section of the Internal Revenue Code that governs how qualifying small business corporations can elect pass-through taxation rather than being taxed as separate entities.
  2. How does a Subchapter S Corporation differ from a C Corporation?
    A C Corporation pays taxes on its profits at the corporate level, while an S Corporation’s income is passed through to shareholders and taxed only once on their individual returns.
  3. Can an LLC choose to be taxed as a Subchapter S Corporation?
    Yes. An LLC can elect to be taxed as an S corporation by filing IRS Form 2553, provided it meets the ownership and eligibility requirements.
  4. Are Subchapter S Corporations recognized in every state?
    Most states recognize S corporations, but some—like New Jersey and California—require separate state-level elections or impose additional fees and franchise taxes.
  5. What happens if an S Corporation fails to meet IRS rules?
    If a corporation violates eligibility requirements or misses filing deadlines, the IRS can terminate its S status, converting it to a C corporation for tax purposes.

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