IRC 1362: S Corporation Election and Eligibility Explained

S Corporations offer a tax advantage by allowing income to pass directly to shareholders, avoiding double taxation. Electing S Corporation status under IRC 1362 requires meeting specific criteria and following precise procedures. This election can significantly impact a business’s financial strategy and tax obligations.

S Corporation Eligibility Requirements

Navigating the path to S Corporation status requires meeting specific eligibility criteria. These requirements ensure that only certain corporations can access the tax benefits associated with S Corporations.

Ownership Limits

A key eligibility requirement for S Corporation status is the restriction on shareholder numbers and types. Under IRC 1361, an S Corporation is limited to 100 shareholders. Family members can be treated as a single shareholder under the family aggregation rule, simplifying compliance for family-owned businesses. Shareholders must be U.S. citizens or resident aliens, as foreign investors, partnerships, corporations, and non-resident aliens are prohibited from owning shares. These limitations are designed to maintain the simplicity and transparency of S Corporations.

Domestic Corporation

To qualify, the entity must be a domestic corporation, incorporated within the United States and subject to its federal tax laws. Foreign corporations or those incorporated outside the U.S. are ineligible. Certain domestic corporations, such as financial institutions, insurance companies, and international sales corporations, are excluded due to their specific regulatory and tax requirements. Businesses must ensure they meet this criterion and fall within the IRS’s permissible categories.

Single Class of Stock

An S Corporation can issue only one class of stock, ensuring uniformity in profit distribution and liquidation rights among shareholders. While differences in voting rights are allowed, all shares must have identical financial rights. Corporations must carefully draft their articles of incorporation and shareholder agreements to comply with this requirement, as any deviation could terminate S Corporation status.

Making the Election

Electing S Corporation status requires submitting Form 2553, Election by a Small Business Corporation, to the IRS. This form must be filed no later than two months and 15 days after the start of the tax year in which the election is to take effect. For example, to be taxed as an S Corporation for 2025, the form must be submitted by March 15, 2025. Missing this deadline can delay the election’s tax benefits.

The form requires details such as the corporation’s Employer Identification Number (EIN), incorporation date, and shareholder information. All shareholders must consent to the election. Any changes to ownership or shareholder agreements should be finalized before filing to avoid complications.

Once the election is approved, the corporation must comply with specific obligations, including filing Form 1120S annually and maintaining accurate records of shareholder distributions and tax basis. Failure to adhere to these requirements can result in the loss of S Corporation status and a reversion to standard corporate taxation.

Effect of Revocation

Revoking S Corporation status changes a corporation’s tax structure. To revoke, the corporation must file a statement with the IRS, signed by shareholders owning more than 50% of the shares. This action reverts the corporation to C Corporation status, subjecting it to corporate-level taxation. The revocation must typically be filed by the 15th day of the third month of the tax year for it to take effect in that year.

This transition introduces double taxation: profits are taxed at the corporate level and again on shareholder dividends. The shift affects cash flow and financial planning, requiring corporations to adjust to corporate income tax rates and dividend taxation. Compliance changes include switching from filing Form 1120S to Form 1120 and adapting accounting practices for retained earnings, dividends, and corporate tax credits. Tax professionals are often engaged to manage this transition.

Return to Corporate Taxation

When a corporation returns to traditional corporate taxation, its financial strategy must adapt to the new framework. Profits are taxed at the corporate level before distribution to shareholders, making the strategic allocation of retained earnings critical. These earnings can be reinvested, used to reduce debt, or reserved for future growth.

The shift may also lead to a reevaluation of the company’s capital structure. With dividends taxed, corporations may consider debt financing, which allows for interest deductibility and reduces taxable income. Additionally, the corporation can explore tax credits, deductions, and incentives under the Internal Revenue Code to mitigate its overall tax burden.