S Corporations: Tax Rules and Requirements

Introduction to S Corporations

Subchapter S of the Internal Revenue Code establishes the framework for S corporations, entities that integrate elements of C corporations and partnerships. An S corporation generally avoids taxation at the corporate level by operating as a pass-through entity. Income, losses, deductions, and credits transfer directly to shareholders, who report these amounts on their personal income tax returns (Form 1040) and pay taxes at individual rates, which range from 10% to 37% for the 2024 tax year according to IRS schedules. This pass-through structure eliminates the double taxation inherent in C corporations, where profits are taxed at the corporate rate of 21% and again as dividends at the shareholder level. Similar to C corporations, S corporations provide shareholders with liability protection, limiting personal exposure to business debts or legal claims—a feature unavailable in general partnerships.

S corporations, however, impose specific restrictions. Profits and losses must be allocated to shareholders in proportion to their stock ownership percentages, without the flexibility partnerships have to adjust allocations through agreements. Distributions of appreciated property—assets with a fair market value exceeding their adjusted basis—generate taxable gains at the corporate level, reported on Form 1120-S, unlike partnerships where such transfers are typically nontaxable. S corporations are confined to issuing one class of stock, though differences in voting rights between shares are permissible under IRC Section 1361. These rules create a distinct tax and operational profile, balancing benefits with structural limitations.

Benefits and Drawbacks of S Corporations

S corporations deliver key advantages through their tax treatment and liability safeguards. By passing income directly to shareholders, they bypass the 21% corporate income tax applied to C corporations, ensuring profits are taxed only once at individual rates. This can reduce the overall tax burden compared to C corporations, where profits face both corporate and dividend taxation. Shareholders also gain liability protection equivalent to that of C corporations, shielding personal assets from business obligations, unlike general partnerships where partners bear unlimited liability for debts.

Limitations offset these benefits. S corporations lack the allocation flexibility of partnerships, requiring profits and losses to follow ownership percentages without deviation. Distributions of appreciated property trigger taxable gains at the corporate level, calculated as the difference between fair market value and adjusted basis, necessitating careful planning. Shareholder restrictions are stringent: a maximum of 100 shareholders, restricted to U.S. citizens, residents, or specific entities like trusts and estates, contrasting with C corporations’ unrestricted ownership rules. In rare instances, S corporations face corporate-level taxes, such as on excess passive investment income or built-in gains from prior C corporation status. Accounting methods—cash or accrual—are elective, but a tax year, typically the calendar year, is mandatory unless an alternative is justified and approved by the IRS.

Electing S Corporation Status

To achieve S corporation status, a corporation must file Form 2553, Election by a Small Business Corporation, with the IRS. For newly formed entities, this filing is due within 2 months and 15 days from the date of incorporation, aligning the election with the start of the first tax year. Existing corporations seeking S status must submit Form 2553 at any point during the preceding tax year or by the 15th day of the third month (March 15 for calendar-year entities) of the tax year in which the election will take effect. Entities formed mid-year with a short initial tax year (less than 2.5 months) must file within 2 months and 15 days from incorporation to apply S status retroactively to the formation date.

All shareholders who own stock during any portion of the tax year prior to the election’s effective date must consent to the election by signing Form 2553, including those who dispose of their shares before the filing date. Late elections, filed after the 2-month-and-15-day window for new entities or March 15 for existing ones, take effect at the start of the following tax year unless the IRS grants relief under Revenue Procedure 2013-30. Relief eligibility requires demonstrating intent to operate as an S corporation, providing reasonable cause for the delay (e.g., administrative oversight), ensuring all tax reporting aligns with S status for the intended year and beyond, and submitting within 3 years and 75 days of the desired effective date. Late filings must include Form 2553 with Form 1120-S, marked “INCLUDES LATE ELECTION PURSUANT TO REV. PROC. 2013-30” on the first page, with the IRS typically responding within 60 days on approval and effective date.

Eligibility Requirements for S Corporations

S corporations must comply with IRC Section 1361 requirements to maintain status. The entity must be a domestic corporation, incorporated under U.S. state law, excluding foreign entities. Shareholder numbers are capped at 100, though spouses and family members (individuals sharing a common ancestor, plus their spouses or former spouses) may be treated as a single shareholder if they elect this designation. Eligible shareholders include U.S. citizens or residents, estates (including bankruptcy estates), certain trusts (e.g., electing small business trusts), and specific tax-exempt organizations like 501(c)(3) corporations. Partnerships, C corporations, and nonresident aliens are prohibited from direct ownership, though S corporations may hold interests in partnerships or C corporation stock.

Only one class of stock is permitted, defined by identical rights to distributions and liquidation proceeds, though variations in voting rights (e.g., voting vs. nonvoting shares) are allowed. An S corporation can own a qualified subchapter S subsidiary (Q-Sub) by filing Form 8869, treating the subsidiary as a disregarded entity for tax purposes, with its income and assets consolidated into the parent S corporation’s return. Failure to meet these criteria—such as exceeding 100 shareholders, adding a nonresident alien, or issuing a second stock class—results in automatic termination of S status, shifting the entity to C corporation taxation.

Filing Obligations for S Corporations

S corporations are required to file Form 1120-S, U.S. Income Tax Return for an S Corporation, annually to report income, deductions, and credits. For calendar-year entities, the filing deadline is the 15th day of the third month following the tax year-end (March 15), with an automatic six-month extension available to September 15 by submitting Form 7004, Application for Automatic Extension of Time, by the original due date. Shareholders receive Schedule K-1 (Form 1120-S), detailing their allocated shares of income, losses, deductions, and credits, which they report on personal tax returns. Filing is mandatory each year, regardless of whether the corporation earns a profit or incurs a loss, continuing until legal dissolution, when a final return is due 2 months and 15 days after the dissolution date.

Since 2023, IRS regulations mandate electronic filing for S corporations issuing 10 or more information returns annually, such as Forms W-2 for employees or Forms 1099 for contractors. This e-filing requirement extends to Form 1120-S and includes reporting financial interests in digital assets (e.g., cryptocurrency) on Schedule B of Form 1120-S. Paper filing is no longer permitted for entities meeting this threshold, ensuring streamlined IRS processing and compliance tracking.

Tax Year Requirements

S corporations are generally required to adopt a calendar year (January 1 to December 31) for tax reporting unless the IRS approves an alternative under IRC Section 444 or based on specific business needs. Permissible alternatives include a natural business year, reflecting a 12-month period ending at a low point in the entity’s activity cycle (e.g., post-harvest for agricultural firms), an ownership tax year aligned with the tax year of shareholders owning more than 50% of the stock (typically calendar for individuals), or a 52-53 week year referencing an approved month-end. To establish or change a tax year, new S corporations file Form 2553 with the desired election, while existing ones submit Form 1128, Application to Adopt, Change, or Retain a Tax Year, justifying the business purpose—such as seasonal revenue patterns—to secure IRS consent.

Shareholder Stock and Debt Basis

A shareholder’s basis in S corporation stock begins with their initial capital contribution or the cost of purchased shares, as outlined in IRC Section 1367. For stock acquired via purchase, basis equals the cash paid. For shares received during S corporation formation under IRC Section 351, basis includes cash contributed and the adjusted basis of transferred property, increased by any recognized gain and decreased by boot (e.g., cash received). Gifted stock adopts the donor’s basis per IRC Section 1015, while inherited stock uses the fair market value at the decedent’s death or alternate valuation date per IRC Section 1014. Debt basis applies exclusively to direct loans from a shareholder to the corporation, excluding third-party loans or guarantees, per Treasury Regulation §1.1367-2.

Basis adjusts annually on the last day of the S corporation’s tax year in this order: increased by income items (e.g., ordinary income, capital gains) and excess depletion; decreased by distributions; reduced by nondeductible, noncapital expenses (e.g., penalties); and finally decreased by losses and deductions. Losses are deductible only up to the combined stock and debt basis, with any excess carried forward indefinitely until basis increases or the stock is sold. Shareholders must file Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, when claiming losses, receiving distributions, disposing of stock, or receiving loan repayments, to document basis calculations and ensure compliance with IRS limits. Debt basis decreases when losses are claimed against it, and repayments of reduced-basis debt may be partially or fully taxable.

Distributions from S Corporations

S corporation distributions must be made pro-rata to all shareholders based on their ownership percentages, occurring on the same date to maintain uniformity. Without accumulated earnings and profits (E&P) from prior C corporation status, distributions are nontaxable up to the shareholder’s adjusted stock basis, reducing basis accordingly, with any excess treated as capital gain and reported on Schedule D (Form 1040). If E&P exists, distributions follow a sequence: first from the Accumulated Adjustments Account (AAA), tax-free and reducing basis; then from E&P, taxable as dividends; followed by the Other Adjustments Account (OAA), tax-free and reducing basis; and finally, any remainder reduces basis or becomes capital gain if basis reaches zero.

Distributions of appreciated property—where fair market value exceeds adjusted basis—trigger a taxable gain at the corporate level, computed as if the S corporation sold the asset, with the gain passing through to shareholders and increasing their stock basis. No loss is recognized if the property’s fair market value falls below its basis. The amount of a distribution includes cash plus the fair market value of any property received, requiring precise valuation and reporting on Form 1120-S.

Limited Taxation of S Corporations

S corporations typically avoid entity-level taxation as pass-through entities, but specific circumstances impose corporate-level taxes, primarily affecting former C corporations:

1. Excess Net Passive Income Tax: Applies when passive investment income (e.g., interest, dividends, rents, royalties) exceeds 25% of gross receipts and the S corporation has accumulated E&P from prior C corporation years. The tax rate is 21%, levied on the lesser of excess net passive income or taxable income calculated as a C corporation, reported on Form 1120-S.

2. Built-in Gains (BIG) Tax: Imposed at 21% on gains from appreciated assets held when a C corporation converts to S status or acquired with a C corporation basis, if sold within 5 years of the S election’s start or acquisition date. The tax targets unrealized gains at conversion, deducted on shareholders’ K-1s.

3. Investment Credit Recapture: Occurs when a C corporation claims a credit (e.g., rehabilitation credit) and converts to S status, then disposes of the credited asset within 5 years. The S corporation reports recapture on Form 4255, not shareholders.

4. LIFO Recapture Tax: Applies to C corporations using the last-in, first-out (LIFO) inventory method upon S election, taxing the difference between first-in, first-out (FIFO) and LIFO values in four equal installments, starting with the final C corporation return.

Additional taxes include payroll taxes for employees, excise taxes (e.g., on fuel, tanning services via Form 720), and state franchise taxes, all reported separately from income tax obligations.

Reasonable Compensation Rules

S corporations must pay shareholder-employees reasonable wages for services rendered before issuing distributions, subjecting wages to payroll taxes—Social Security (6.2% employer, 6.2% employee), Medicare (1.45% each), and FUTA (up to 6%). Distributions, taxed only as income, avoid these levies, but inadequate wages may prompt the IRS to reclassify distributions as wages, adding employment taxes, penalties, and interest. Reasonable compensation hinges on factors like experience, responsibilities, time commitment, industry standards, and payments to non-shareholders, per IRS guidelines and court precedents. Officers performing minimal or no services are exempt from this requirement and may receive no wages.

Section 199A Qualified Business Income Deduction

Under IRC Section 199A, S corporation shareholders may deduct 20% of qualified business income (QBI)—ordinary income excluding reasonable compensation wages paid to them—subject to income thresholds ($182,100 single, $364,200 joint for 2024) and limitations based on wages paid and qualified property. All wages, including to shareholders, factor into these limits, calculated on Form 1040 with supporting worksheets, enhancing tax savings for eligible pass-through income.

Health Insurance for Shareholders

Health insurance premiums for shareholders owning 2% or more are deductible by the S corporation as compensation, included as wages on Form W-2, and excluded from Social Security, Medicare, and FUTA taxes. These shareholders may deduct premiums as an adjustment to income on Form 1040 if the S corporation pays or reimburses them and reports the amount on W-2s—not via Schedule K-1 or Form 1099. Premiums for non-shareholders or <2% owners are deductible as business expenses and tax-free to recipients. Deductibility ceases if the shareholder or spouse has access to a subsidized plan from another employer, even if declined.

Termination of Shareholder Interest

A shareholder terminating their S corporation interest through sale or disposal reports the transaction on Schedule D, calculating gain or loss as the difference between the sale price and adjusted basis. Mid-year terminations allow an election under IRC Section 1377(a)(2), with consent from all affected shareholders, to treat the tax year as two separate periods—pre- and post-termination—allocating income and losses accordingly. The corporation attaches a statement to Form 1120-S, noting “SECTION 1377(a)(2) ELECTION MADE” on affected K-1s, filed by the regular or extended deadline.

Termination or Revocation of S Status

S corporation status persists until terminated by: failure to meet eligibility (e.g., exceeding 100 shareholders, adding a nonresident alien), deriving over 25% of gross receipts from passive income with E&P for three consecutive years, issuing a second stock class, or a majority (>50%) shareholder revocation via a signed statement filed with the IRS service center. No specific revocation form exists—shareholders owning over 50% of stock (voting and nonvoting) must sign. Revocations filed by March 15 of a tax year are effective January 1; later filings apply to the next year unless a future date is specified. Termination splits the year into S and C periods, requiring Form 1120-S for the S portion and Form 1120 for the C portion, due per respective deadlines.

Inadvertent terminations—unintentional breaches like disproportionate distributions or shareholder limit violations—take effect on the triggering date but may be remedied under Revenue Procedure 2022-19 without a private letter ruling ($10,000+ fee) if the cause was uncontrollable and unplanned. Relief covers one-class stock errors, Form 2553/8869 omissions, and similar issues, restoring S status retroactively. Post-termination, re-election is prohibited for 5 years (60 months) unless the IRS waives this restriction upon request.