Key Takeaways

  • A small business corporation must meet IRS eligibility rules under Subchapter S to maintain S Corporation status.
  • The revocation of S corporation status can be voluntary (shareholder decision) or involuntary (IRS termination due to noncompliance).
  • Common causes of revocation include exceeding the shareholder limit, adding ineligible shareholders, or issuing multiple classes of stock.
  • Revocation typically requires consent from shareholders holding more than 50% of the shares.
  • Once revoked, an S corporation generally cannot re-elect S status for five years, unless the IRS grants early reinstatement.
  • The IRS may permit retroactive reinstatement if termination was inadvertent and corrective actions were taken promptly.
  • Revocation impacts not only the corporation but also qualified subchapter S subsidiaries (QSUBs), which revert to taxable C corporations.
  • Filing procedures, effective dates, and rescission options are specific and time-sensitive.
  • Consulting an experienced tax attorney can help businesses navigate S corporation revocation and reinstatement.

The requirements for small business corporations are crucial for you to understand if you are planning on forming one. Understanding the caveats of forming a corporation versus forming other entity types will allow you to make the best decision.

Small Corporation Business Definition

There are several definitions of a small business.

  • According to the IRS Subchapter S election guideline, a small business must have less than 100 shares to make a subchapter S election.
  • A Small Business Corporation is also defined as a corporation which raises money from investors and have a paid-in surplus totaling no more than $1,0000,000  and meets all other guidelines outlined in the Internal Revenue Code (26 USCS § 1244 (c)). This code allows shareholders to claim ordinary losses on valueless stock.
  • According to USCS § 1361, a small business corporation is a domestic corporation who is not owned by another corporation or a non-US citizen and only has one class of stock.

Eligibility Criteria for a Small Business Corporation

To qualify as a small business corporation under IRS rules, a company must meet several requirements:

  • Be a domestic corporation incorporated in the United States.
  • Have no more than 100 shareholders.
  • Issue only one class of stock.
  • Ensure that shareholders are individuals, certain trusts, or estates—not partnerships, other corporations, or nonresident aliens.

For Canadian tax purposes, a small business corporation may also be defined differently, often as a Canadian-controlled private corporation where all or substantially all (90% or more) of the fair market value of its assets is used in an active business in Canada.

What Exactly Is a Corporation?

The difference between other business entities and a corporation is that a corporation legally stands on its own. Thus, a corporation is a separate entity from its owners. In other words, a corporation is its own "person" and therefore can do the following:

  • Create contracts
  • Acquire debt
  • File taxes
  • Exist after the original owners die

Moreover, business owners who form a corporation have limited liability protection within a corporation. 

Types of Small Business Corporations

Small business corporations can take different forms depending on tax elections and jurisdiction:

  • C Corporations (C Corps): Default corporate form, taxed separately from owners. Profits may be subject to double taxation, once at the corporate level and again when distributed as dividends.
  • S Corporations (S Corps): Special tax status that allows profits and certain losses to pass through to shareholders, avoiding double taxation. Requires filing Form 2553 with the IRS and meeting shareholder and stock restrictions.
  • Professional Corporations (PCs): Formed by licensed professionals (e.g., attorneys, doctors) and may have additional state-level regulations.

What Is Limited Liability and Why Is it Important?

Limited liability means that a corporate shareholder does not risk being personally liable for the corporation's debt. It is important because in most cases, an owner cannot be personally held liable his company's debts and liabilities. Suppose a corporation is sued for a debt and the creditor wins the suit. The creditor can only go after the corporation's assets.

Keep in mind that the corporation must adhere to certain guidelines to maintain shareholder protection. Furthermore, owners must show that the corporation indeed works as its own entity.

Maintaining Limited Liability Status

Limited liability protection can be lost if corporate formalities are not followed, a situation known as “piercing the corporate veil.” To protect personal assets:

  • Keep corporate and personal finances separate.
  • Maintain accurate corporate records and hold required meetings.
  • Operate within the scope of corporate authority and comply with state filings.

Failure to observe these rules can expose shareholders to personal liability for corporate debts and obligations.

Are Corporations Different from Partnerships, Sole Proprietorships, or LLCs?

Corporations are different because they offer a protection you can't get from a partnership and sole proprietorship.  A corporation offers a special kind of protection. The corporate status shields your personal assets from corporate liabilities and debt.

The only other entity that offers this type of protection is a limited liability company (LLC). LLCs also offer their owners limited personal liability protection. While it requires paperwork to form, it is easier to maintain your LLC status compared to a corporation. For instance, LLC owners are not subject to strict corporate mandates like holding regular shareholder meetings.

Still, the biggest difference between corporations and other business entities is how they are taxed. Since a corporation is treated as a "person," it is subject to taxes. Corporations pay taxes on profits less all expenses including salaries, bonuses, overhead and other expenses. LLCs, partnerships, and sole proprietorships, on the other hand, are not taxed. Instead, the taxes pass through to the owners. Hence, the owners file their portion of profits or losses on their own tax returns.

Tax Advantages of a Small Business Corporation

Small business corporations—especially those electing S corporation status—can enjoy several tax benefits:

  • Pass-through taxation for S corporations, meaning profits and certain losses are reported on shareholders’ personal tax returns.
  • Potential for deducting business losses against other income, subject to IRS rules.
  • For qualified Canadian small business corporations, shareholders may benefit from a lifetime capital gains exemption on the sale of shares, up to a certain limit.
  • Ability to retain earnings in a C corporation for reinvestment at corporate tax rates.

Who Would Benefit from Forming a Corporation?

You should not form a corporation for the limited liability benefits since you get those same benefits if you form an LLC. However, you may benefit from forming a corporation in the following situations:

  • You want to attract and retain highly skilled employees by offering them stock options.
  • Your business is highly profitable, and you want to save on taxes.
  • You are running a family business and want to gift shares without losing ownership or control of your business.
  • You have an opportunity to have strategic partnerships or high-revenue generating clients, but they require you to have a corporate status.

When an S Corporation Election Makes Sense

An S corporation election may be advantageous when:

  • The business generates consistent profits that can be distributed without being taxed twice.
  • Shareholders want to avoid self-employment tax on distributions, while still paying themselves reasonable salaries subject to payroll tax.
  • Owners want to attract investors but still operate with pass-through taxation benefits.

However, an S corporation election is not always ideal for businesses planning to issue multiple classes of stock or seek significant outside investment from entities not eligible as shareholders.

How to Form a Small Business Corporation

  • File your articles of incorporation with your states Secretary of State's office or the governing body that handles entity formation in your state.
  • Make sure to include your business's legal address as well as the information for your corporation's registered agent.
  • Create your corporate by-laws which govern how you run your business and meet with your shareholders to issue stock before you open for business.

Ongoing Compliance Requirements

Once formed, a small business corporation must comply with ongoing obligations, which may include:

  • Filing annual reports with the state.
  • Holding annual shareholder and director meetings and keeping minutes.
  • Filing federal and state corporate tax returns.
  • Maintaining accurate corporate records and updated bylaws.

Failure to meet these requirements can result in penalties, loss of good standing, or dissolution of the corporation.

Understanding the Revocation of S Corporation Status

The revocation of S corporation status refers to the process by which a business loses its S election—either voluntarily through shareholder action or involuntarily due to IRS enforcement. Under IRC §1362, the IRS can automatically terminate S status if a corporation no longer meets eligibility requirements such as shareholder restrictions, stock class limitations, or ownership qualifications.

Voluntary Revocation

A corporation may voluntarily revoke its S election by obtaining written consent from shareholders owning more than 50% of issued shares on the date of revocation. The revocation must be filed with the same IRS Service Center where Form 1120-S is submitted. Businesses often choose this route when planning to restructure, attract corporate investors, or avoid limitations imposed by S corporation rules.

  • The revocation is effective on the date specified in the revocation statement.
  • If no date is specified, the timing depends on when the revocation is filed:
    • Filed before the 15th day of the third month → effective on the first day of that year.
    • Filed after that date → effective on the first day of the next taxable year.
  • Revocation can also be rescinded prior to becoming effective with unanimous shareholder consent.

Involuntary Revocation by the IRS

The IRS may revoke S corporation status if the entity violates Subchapter S rules, including:

  • Exceeding 100 shareholders,
  • Adding ineligible shareholders (such as partnerships, corporations, or nonresident aliens),
  • Issuing more than one class of stock, or
  • Failing to adhere to filing or income rules.

Such revocations are often automatic and can have retroactive tax effects, converting the corporation into a C corporation for the affected tax year.

Tax Implications and Reinstatement After Revocation

Once S corporation status is revoked, the company becomes a C corporation for tax purposes, subjecting profits to potential double taxation (corporate and shareholder levels). This transition also affects any Qualified Subchapter S Subsidiaries (QSUBs), which automatically lose their disregarded entity status and become taxable C corporations.

If the corporation later seeks to re-elect S corporation status, several important rules apply:

  • A five-year waiting period typically applies before re-election is permitted.
  • The IRS may grant early reinstatement if the corporation demonstrates no tax avoidance motive and full compliance with corrective measures.
  • If the termination was inadvertent and corrective actions were taken promptly, the IRS may allow retroactive reinstatement under IRC §1362(f).

When reapplying for S status, the business must:

  1. File Form 2553 (Election by a Small Business Corporation), signed by all shareholders.
  2. Ensure eligibility criteria are restored (for example, removing an ineligible shareholder).
  3. Wait for IRS approval before treating the corporation as an S corporation again.

Preventing S Corporation Revocation

Maintaining compliance with S corporation eligibility rules is essential to avoid unintentional revocation. Best practices include:

  • Monitoring shareholder eligibility to ensure only individuals, certain trusts, or estates hold shares.
  • Tracking ownership changes to avoid exceeding the 100-shareholder limit.
  • Issuing only one class of stock to prevent automatic termination.
  • Staying current on tax filings and distributions consistent with shareholder interests.
  • Maintaining detailed records of all shareholder consents and revocation-related correspondence.

Failure to do so can not only result in loss of S status but also create complex tax liabilities for both the corporation and its shareholders.

Frequently Asked Questions

  1. What happens when S corporation status is revoked?
    The corporation becomes a C corporation for tax purposes, subject to corporate-level taxation on income and potentially double taxation on dividends.
  2. Can an S corporation voluntarily revoke its status?
    Yes. Shareholders owning more than 50% of shares can consent to revoke S status by filing a written revocation statement with the IRS.
  3. How long must a company wait to re-elect S corporation status after revocation?
    Typically, the IRS requires a five-year waiting period unless early reinstatement is approved due to reasonable cause.
  4. What are common reasons for the IRS to revoke S corporation status?
    Common triggers include exceeding 100 shareholders, adding an ineligible shareholder, or issuing multiple stock classes.
  5. Can a revoked S corporation regain its status retroactively?
    Yes, under IRC §1362(f), the IRS may allow retroactive reinstatement if the termination was inadvertent and corrective actions were taken promptly.

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