Key Takeaways

  • S corporations must meet IRS eligibility requirements including entity type, shareholder count, and citizenship/residency.
  • To elect S corp status, eligible corporations must file IRS Form 2553 within a specified timeframe.
  • S corps offer pass-through taxation and limited liability but have restrictions on shareholders and stock classes.
  • Filing deadlines and compliance vary by state, and late elections may require IRS relief.
  • S corps must adopt a calendar tax year unless special approval is obtained for a fiscal year.

Definition of a Subchapter S Corporation

Understanding the requirements for S corporation can help business owners avoid legal issues and expensive, time-consuming business entity changes. An S corporation is a standard corporation with at least 1 shareholder but no more than 100. S corporations can also take advantage of pass-through taxation, which means that all net losses and income are passed through the business to the shareholders, based on IRS Code Chapter 1, Subchapter S.

All corporations must meet certain criteria to be eligible for this type of business formation. Additionally, the shareholders of an S corporation must submit a required form to the IRS within a specific period of time to elect this treatment. S corporations offer the appealing limited liability protection, along with perpetual existence and opportunities for investment. An S corporation is classified as a pass-through business entity. 

All corporations must be formed under the laws of the state in which they will operate. When a corporation is first formed, it is a C corporation by default. After filing the necessary formation documents with the proper state office, such as the Secretary of State's office, the shareholders must give consent to elect for treatment as an S corporation.

Since an S corporation is a type of corporation, it will be formed when its articles of incorporation are filed with the appropriate governmental agency. S corporations are governed in the same way as C corporations and can issue stock. Additionally, they have shareholders, officers, and directors who will perform the same business functions as those within C corporations. 

The owners of the company, or shareholders, maintain the same level of liability protection as those who own a C corporation. This means that the personal bank accounts or other personal assets of S corporation shareholders generally can't be taken to pay off or satisfy any outstanding liabilities of the business.

S Corp Eligibility Requirements

To qualify as an S corporation under IRS rules, a business must meet strict eligibility requirements:

  • Be a Domestic Corporation: The business must be incorporated in the U.S.
  • Have Only Eligible Shareholders: Shareholders must be individuals, certain trusts, or estates. Partnerships, corporations, and non-resident aliens are not permitted as shareholders.
  • Limit on Number of Shareholders: The S corporation may not have more than 100 shareholders.
  • One Class of Stock: S corporations can only issue one class of stock, though voting rights may differ.
  • Consent of All Shareholders: All shareholders must consent to the S corporation election.

Failure to meet these requirements at any point can result in the loss of S corporation status.

Taxation of Regular Corporations

A standard corporation, also referred to as a C corporation, is a business entity that exists separately from its shareholders for tax purposes. The term C corporation comes from the IRS Code, Chapter 1, Subchapter C. C corporation tax rates apply only to businesses formed as corporations. This type of business entity will also use its own specific IRS tax form, 1120.

Shareholders of a corporation can opt to retain earnings and profits as part of their operating capital. The other option is to distribute any or all of the earnings and profits, which are paid as dividends to the other shareholders of the company. These dividends, which are paid to the corporation's shareholders, are double-taxed.

The double taxation includes:

  • Corporate-level taxation, which is reported on IRS Form 1120
  • Individual-level taxation, which is reported on the shareholder's personal IRS Form 1040

The default tax status for all corporations is taxation as a C corporation. In order to change to S corp taxation, the shareholders must file a form to specify the tax status with the IRS. 

Taxation of S Corporations

S corporations are not subject to corporate tax rates. In general, S corporations are exempt from federal income taxes. The only exceptions with the IRS are on passive income and specific capital gains. Instead of being taxed on its income, the S corporation can pass its net losses and profits through the business to its shareholders. Each individual shareholder must pay taxes on the business profits on their personal tax Form 1040. Pass-through taxation, also referred to as flow-through taxation, ensures that the profits of a corporation are taxed one time, on the shareholders' personal tax returns.

As the IRS explains, the shareholders of an S corporation must include their share of any credits, losses, deductions, and income from the business. They must also report their shares of income or losses that are stated non-separately. Therefore, an S corporation can avoid the dreaded double taxation of its dividends.

Similar to a C corporation, an S corporation can elect to retain its net profits to keep as operating capital within the business. However, tax rules will apply in the same way as if the dividends were distributed to the company's shareholders. Therefore, shareholders within an S corporation could be required to pay taxes on income they didn't receive. This is one benefit of a C corporation since its shareholders will only have to pay taxes on dividends that have been paid out.

Calendar vs. Fiscal Year for S Corps

Generally, S corporations must use a calendar year as their tax year, ending December 31. To adopt a fiscal year (any year-end other than December 31), the corporation must:

  • Demonstrate a valid business purpose.
  • File Form 2553 along with Form 8716 (Election To Have a Tax Year Other Than a Required Tax Year).
  • Receive IRS approval for the change.

Failure to obtain this approval may lead to penalties or rejection of the S corp election.

State-Specific S Corp Requirements

In addition to federal requirements, each state has its own rules regarding S corporation status. Some states recognize federal S corp elections automatically, while others require a separate state-level filing. For example:

  • California: Requires the filing of Form 100S and imposes a state franchise tax.
  • New York: Requires filing of Form CT-6 to elect S corp treatment for state purposes.
  • New Jersey: Needs Form CBT-2553 to align with federal treatment.

Check with your state’s tax authority to ensure compliance with all local requirements for maintaining S corporation status.

Filing Form 2553 and Election Deadlines

To elect S corporation status, an eligible business must file IRS Form 2553, “Election by a Small Business Corporation.” This form must be signed by all shareholders and submitted:

  • No more than two months and 15 days after the beginning of the tax year when the election is intended to take effect.
  • Or at any time during the preceding tax year.

If this deadline is missed, the IRS may still grant relief for late elections under certain circumstances. Relief is typically available if the corporation can demonstrate reasonable cause for the delay and acted diligently to correct the issue.

Frequently Asked Questions

  1. What are the main S corp requirements?
    A corporation must be domestic, have no more than 100 eligible shareholders, offer only one class of stock, and file IRS Form 2553 on time to elect S corp status.
  2. Can an LLC elect S corp status?
    Yes, an LLC can elect to be taxed as an S corporation by filing Form 2553 if it meets IRS eligibility rules.
  3. What happens if you file Form 2553 late?
    You may request late election relief from the IRS, but you must provide reasonable cause for the delay and take corrective action promptly.
  4. Do all states recognize S corporations?
    Not all states follow federal S corp rules. Some require separate state-level elections or filings to maintain the status for state tax purposes.
  5. Can non-U.S. residents own shares in an S corp?
    No. Only U.S. citizens or resident aliens can be shareholders of an S corporation.

If you need help with the requirements for S corporation, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.