S Corp for Dummies: A Simple Breakdown of Rules and Benefits

An S Corporation (S Corp) offers small business owners tax advantages while maintaining liability protection. It avoids double taxation while preserving corporate legal benefits. However, not all businesses qualify, and strict IRS rules apply.

Eligibility Requirements

To qualify for S Corp status, a business must be a domestic corporation. Limited liability companies (LLCs) can elect this status but must meet corporate structural requirements.

Ownership is restricted to 100 shareholders, who must be individuals, certain trusts, or estates. Partnerships, corporations, and non-resident aliens cannot hold shares. Violating these restrictions results in the loss of S Corp status and potential tax consequences.

An S Corp can issue only one class of stock, meaning all shares must have equal rights to distributions and liquidation proceeds. While differences in voting rights are allowed, financial rights must remain the same to maintain eligibility.

Tax Election Procedure

Electing S Corp status requires filing Form 2553, “Election by a Small Business Corporation,” with the IRS. This form must be submitted within two months and 15 days after the start of the tax year for which the election applies. If the deadline is missed, the election generally takes effect the following year unless late election relief is granted.

All shareholders must unanimously consent by signing Form 2553. If any shareholder refuses, the election cannot proceed. New shareholders must also comply with S Corp requirements.

State-level requirements vary. Some states require a separate election, while others automatically recognize the federal designation. Certain states impose franchise taxes or other fees, affecting potential tax savings. Business owners should verify their state’s rules to avoid unexpected obligations.

Taxation and Distributions

S Corps pass income, deductions, and credits directly to shareholders, eliminating corporate-level taxation. Shareholders report their allocated income on personal tax returns, even if earnings are retained.

Distributions are generally tax-free unless they exceed the shareholder’s stock basis, which consists of the initial investment, income allocations, and losses. Any excess is taxed as a capital gain. Proper basis tracking prevents unexpected tax liabilities.

Shareholder-employees must receive a reasonable salary before taking distributions. The IRS enforces this to ensure Social Security and Medicare taxes are properly paid. If salaries are unreasonably low, the IRS can reclassify distributions as wages, subjecting them to payroll taxes and penalties. A reasonable salary depends on industry standards, company profitability, and the individual’s role.

Recordkeeping and Compliance

Accurate financial records are essential for IRS compliance and transparency. Businesses must maintain detailed books tracking income, expenses, shareholder basis, and distributions. Poor recordkeeping can lead to misreported income and IRS penalties for tax understatement. Accounting software can assist, but businesses must also retain bank statements, invoices, and payroll records for at least three years, per IRS guidelines.

S Corps must follow corporate governance rules, including holding annual shareholder meetings, maintaining minutes, and documenting major business decisions. Failure to observe these formalities can expose shareholders to personal liability if courts determine the corporation lacks legal separation, as seen in Laya v. Erin Homes, Inc., 352 S.E.2d 93 (W. Va. 1986).

Termination and Revocation

S Corp status is not permanent. Businesses may voluntarily revoke it or lose it due to noncompliance, reverting to C Corporation taxation.

Voluntary revocation requires a written statement to the IRS, signed by shareholders owning more than 50% of the stock. If no termination date is specified, revocation typically takes effect at the start of the tax year if filed by March 15. Businesses that revoke their election cannot reapply for five years without IRS approval.

Involuntary termination occurs if a corporation violates S Corp requirements, such as exceeding the 100-shareholder limit or issuing a second class of stock. The IRS does not issue automatic warnings, so businesses must monitor compliance. If a violation is corrected promptly, relief may be available through IRS procedures. If termination occurs, the corporation must file a final S Corporation tax return on Form 1120-S and begin filing as a C Corporation in subsequent years.