S Corp Qualifications & IRS Rules Explained

Key Takeaways

• To qualify as an S corporation, a business must meet IRS eligibility rules, including entity type, shareholder limits, and share structure.
• S corp qualifications prohibit entities like partnerships, insurance companies, and certain financial institutions from electing S corp status.
• Businesses must follow proper election procedures, including filing IRS Form 2553 by key deadlines.
• Late S corp election may be permitted under specific IRS relief provisions.
• Maintaining S corp status requires ongoing compliance with IRS rules and shareholder limitations.
• To qualify as an S corporation, a business must meet IRS eligibility rules, including entity type, shareholder limits, and share structure.
• S corp qualifications prohibit entities like partnerships, insurance companies, and certain financial institutions from electing S corp status.
• Businesses must follow proper election procedures, including filing IRS Form 2553 by key deadlines.
• Late S corp election may be permitted under specific IRS relief provisions.
• Maintaining S corp status requires ongoing compliance with IRS rules and shareholder limitations.

What Is an S Corporation?

An S corporation is a business entity that allows pass-through taxation through income and losses to the shareholders for corporate taxation purposes. An S corporation is one of three of the most popular choices for business owners incorporating their business. The other most common choices are limited liability corporations and C corporations. To qualify as an S corporation, a business must meet the IRS eligibility requirements and follow two steps before they are considered a corporation.

• It must file Articles of Incorporation with their state's Secretary of State office.
• Similar to a C corporation, it must issue stocks as determined by their Articles of Incorporation to directors, owners, and shareholders.

Personal Service Corporation 

A PSC, or personal service corporation, is a type of C corporation that receives classification by the IRS for performing services such as consulting. Since C corporations are often assessed with a lower initial rate, often 15 percent on earnings up to $50,000, many businesses will incorporate as an S corporation to avoid being classified by the IRS as a PSC.

How are C Corporations Taxed?

A C corporation is often referred to as a regular corporation and is subject to double taxation. A corporation will file their own Form 1120, or corporate tax return. A corporation can choose to retain its earnings and profits as operating capital or distribute their profits to the shareholders as dividends. When this occurs, the dividends paid to the shareholders will end up being taxed twice, once at the corporate level and again on the shareholder's personal tax return.

How are S Corporations Taxed?

S corporations are not subject to IRS corporate tax rates. In general, an S corporation will be exempt from the federal income tax aside from the tax on certain capital gains. The S corporation will instead use pass-through taxation where the taxes will occur on the profits and losses that the shareholder has accrued on their personal tax return. This ensures that the corporation will only be taxed at the shareholder level.

Similar to C corporations, S corporations can also retain the net profits that they earn for operating capital, though these profits will be treated the same as dividends for tax purposes. Unfortunately, this can result in shareholders having to pay taxes on dividends that they never received. Along with the single taxation, S corporations are attractive to business owners due to their limited liability protection.

What are the Eligibility Requirements for S Corporations?

To be classified as an S corporation, a business will need to meet certain criteria, including:

• The company must be a corporation or entity that operates and is based in the United States.
• The company must have less than 100 total shareholders.
• Shareholders must be estates, individuals, trusts, or a specific exempt organization.
• No shareholders can be a nonresident alien.
• The company stock can only have one class, although it is allowed to have both voting and nonvoting shares. In essence, all investors must have the same dividend and distribution rights.
• A corporation cannot be an ineligible corporation. These corporations include:
  • Banks, which utilize a reserve accounting method for bad debts
  • An insurance company, which require different taxation
  • A corporation treated as a possession
  • A domestic international sales corporation.
• The corporation must have a tax year that has been specifically established for business purposes or one that ends on December 31st.  

All shareholders must agree to the election of the S corporation status. If these restrictions are not followed, the IRS will automatically classify the business as a C corporation, and it will be subject to double taxation.

Additional IRS Requirements for S Corp Qualifications

In addition to the core eligibility rules, the IRS outlines several detailed conditions a corporation must meet to elect and retain S corporation status:

• Timely Filing of Form 2553: The business must file IRS Form 2553 to elect S corp status. This form is typically due no later than two months and 15 days after the beginning of the tax year in which the election is to take effect.
• Consent from All Shareholders: Every shareholder must consent to the S election in writing. The IRS will reject the election if even one eligible shareholder fails to consent.
• Permissible Entity Types: Only certain domestic corporations or eligible LLCs can elect to be taxed as an S corporation. Ineligible entities include partnerships, certain banks and insurance companies, and foreign corporations.
• Shareholder Citizenship: All shareholders must be U.S. citizens or permanent residents. Nonresident aliens are not permitted to own shares.
• Stock Requirements: The corporation may only issue one class of stock. Differences in voting rights are allowed, but all shares must provide the same financial rights.

These requirements are strictly enforced, and failure to meet any one of them can result in disqualification or revocation of S corp status.

Advantages of S Corporations

The advantages of becoming an S corporation often outweigh the disadvantages and include:

• Easier transfer of ownership without tax consequences in the event of an owner's death or departure.
• Limited liability for business debts.
• An unlimited number of management positions with no state residency requirements.
• Shareholders can receive dividends as well as other forms of tax-free distributions.
• S corporations will not have to use the accrual method of accounting unless they have an inventory.
• Owners will not be subject to self-employment taxes that can occur in other tax classifications.

Maintaining S Corporation Status

Once elected, a corporation must continue to meet S corp qualifications to retain its status. Key ongoing compliance requirements include:

• Adhering to Shareholder Limits: The number of shareholders must not exceed 100. If this threshold is surpassed, the S corp status is automatically terminated.
• Maintaining a Single Class of Stock: Offering preferred shares or varying distribution rights can jeopardize the S election.
• Avoiding Ineligible Shareholders: If shares are transferred to a nonresident alien, partnership, or disqualified trust, the S status will be revoked.
• Timely Tax Filings: S corporations must file Form 1120-S annually and provide Schedule K-1s to each shareholder.
• Recordkeeping and Documentation: The business must maintain accurate records of shareholder agreements, elections, and ownership percentages.

Violations of these rules can result in the loss of S corporation status, subjecting the business to C corporation taxation and potential IRS penalties.

How to Elect S Corporation Status

To become an S corporation, a business must follow a specific process that includes both state and federal steps:

1. Form the Corporation or LLC: Incorporate your business with the appropriate state agency, typically the Secretary of State.
2. Obtain an EIN: Apply for an Employer Identification Number (EIN) from the IRS, which is required for federal tax filings.
3. Prepare and File IRS Form 2553: Submit this form to the IRS to officially elect S corporation tax status. The form includes information about the corporation, its shareholders, and the effective date of the election.
4. Meet the Filing Deadline: For new businesses, Form 2553 must generally be filed within 75 days of incorporation. For existing businesses, it must be filed by March 15 to apply for the current tax year.
5. State-Level Requirements: Some states require additional filings or fees to recognize S corporation status for state income tax purposes. Be sure to check with your state's tax agency.

Failure to file timely may require requesting late election relief, which the IRS grants under specific conditions.

Frequently Asked Questions

1. What happens if I miss the deadline to file Form 2553?
   You may still qualify for late election relief if the delay was due to reasonable cause and all shareholders intended for the election to take effect on time.
2. Can an LLC elect to be treated as an S corp?
   Yes, an LLC can elect S corp tax status by filing Form 2553 if it meets all IRS S corporation qualifications.
3. Are there ongoing requirements to maintain S corp status?
   Yes. You must stay under the shareholder limit, keep only one class of stock, and avoid disqualified shareholders like nonresident aliens or partnerships.
4. Do S corps pay federal income taxes?
   Generally, no. S corps use pass-through taxation, so income is taxed on shareholders' personal returns. However, they may pay tax on certain capital gains or passive income.
5. Can an S corp lose its status?
   Yes. Violating IRS rules—like exceeding 100 shareholders or issuing a second class of stock—can cause automatic termination of S corporation status.

If you need help navigating S corporation rules and eligibility requirements, 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.