An S corporation is not a separate type of business entity; it is a federal tax election that lets an eligible corporation, or an LLC taxed as a corporation, pass its income, losses, deductions and credits through to its owners instead of paying federal corporate income tax. It can reduce employment taxes for owners who work in the business, but it comes with strict eligibility rules: no more than 100 shareholders, only eligible shareholders (generally U.S. citizens and residents, not other companies), and only one class of stock.
What Is an S Corporation?
“S corporation” refers to Subchapter S of the Internal Revenue Code. A corporation that elects S status generally does not pay federal income tax at the entity level. Instead, each shareholder reports a pro rata share of the company’s income and losses on a Schedule K-1 and pays tax on it personally, whether or not the cash is distributed. A C corporation, by contrast, pays corporate tax on its profits, and shareholders pay tax again on dividends.
Two points are often misunderstood:
- The election is about taxes, not liability. Limited liability comes from forming a corporation or LLC under state law and respecting its formalities, not from the S election.
- LLCs can elect S status. An eligible LLC can elect to be taxed as a corporation and then as an S corporation (typically by filing Form 2553 alone) while remaining an LLC under state law.
Eligibility Requirements
To elect and keep S status, the company must be a domestic entity and must meet these requirements at all times:
- No more than 100 shareholders. Family members can be counted as one shareholder for this purpose.
- Only eligible shareholders. Generally individuals who are U.S. citizens or resident aliens, estates, and certain trusts and tax-exempt organizations. Partnerships, corporations, most LLCs taxed as partnerships, and nonresident aliens cannot be shareholders.
- One class of stock. All outstanding shares must have identical rights to distributions and liquidation proceeds. Differences in voting rights alone are permitted, so voting and nonvoting common stock is allowed.
Making the Election
The election is made on IRS Form 2553, which must be signed by the company and consented to by every shareholder at the time of the election (and, in some cases, by anyone who held shares earlier in the year). To be effective for the current tax year, it generally must be filed no later than two months and 15 days after the start of that tax year, or at any time during the preceding tax year. Otherwise it usually takes effect the next year, though IRS late-election relief is often available.
California generally follows the federal election; no separate state election is usually required.
Benefits of S Corporation Status
- One level of federal tax. Business income is taxed to the owners, avoiding the corporate-level tax and the second tax on dividends.
- Possible employment tax savings. Working owners take a reasonable salary subject to payroll taxes; remaining profits are generally not subject to Social Security and Medicare taxes.
- Pass-through deductions. S corporation owners may be eligible for the qualified business income deduction under Section 199A, subject to its limits.
California Taxes on S Corporations
California does not fully follow the federal pass-through model. An S corporation pays a 1.5% franchise tax on its California net income, subject to the $800 annual minimum franchise tax, and its shareholders also pay personal income tax on their share of the income. Newly formed corporations are generally exempt from the minimum tax for their first taxable year, but not from the 1.5% tax on income. California’s elective pass-through entity tax may also be worth discussing with your tax advisor.
Common Pitfalls
Contributing property later
Unlike a partnership, a corporation (including an LLC taxed as an S corporation) is subject to Section 351. A contribution of property is tax-free only if the contributors, as a group, control at least 80% of the company immediately afterward. Suppose a new owner contributes a client list or other goodwill with no tax basis in exchange for a 10% interest. If the 80% control test is not met, the new owner may recognize taxable gain.
Converting an existing business
When an LLC elects to be taxed as a corporation, it is treated as contributing its assets to a new corporation. If the liabilities transferred exceed the tax basis of the assets, gain can result. A C corporation that converts to S status may also owe the built-in gains tax if it sells appreciated assets within the five-year recognition period after the conversion.
Accidentally creating a second class of stock
For LLCs, the risk often sits in the operating agreement. Partnership-style provisions, such as liquidating distributions based on capital accounts, preferred returns or special allocations, can produce distribution rights that are not identical. LLCs electing S status should adopt an operating agreement drafted for that purpose.
Admitting an ineligible owner
A transfer of shares to a nonresident alien, a corporation, a partnership or an ineligible trust terminates the election. Shareholder agreements should restrict such transfers.
If the Election Is Invalid or Terminated
If the company was never eligible, the election may be invalid from the start. If it later becomes ineligible, the election terminates on the date of the disqualifying event, and the company is taxed as a C corporation from then on, generally for five years unless the IRS consents to an earlier re-election. The IRS can grant relief for inadvertent problems that are corrected promptly, so act quickly.
Compliance Requirements
- File federal Form 1120-S by the 15th day of the third month after year-end (March 15 for calendar-year companies), unless extended, and issue Schedule K-1s to shareholders.
- File California Form 100S and pay the franchise tax.
- Run payroll for shareholder-employees, including federal Forms 941 and 940, W-2s and California payroll filings.
When an S Corporation Makes Sense
An S corporation often works well for profitable, owner-operated businesses with a small number of U.S. owners that do not plan to bring in institutional investors. It is usually a poor fit for startups seeking venture capital, because funds cannot be shareholders and preferred stock would be a second class of stock. S corporation stock also does not qualify for the qualified small business stock exclusion, which can be valuable to founders of C corporations.
The Takeaway
The S election can save meaningful tax for the right business, but it is unforgiving about eligibility. Choose it deliberately, align your governing documents, and revisit it if your ownership or fundraising plans change.
Frequently Asked Questions
Does forming an LLC make it an S corporation?
No. An LLC is a state-law entity, and S corporation status is a federal tax election. An eligible LLC can elect to be taxed as a corporation and then as an S corporation, usually by filing Form 2553, but it remains an LLC under state law and should keep its operating agreement consistent with the one-class-of-stock rule.
Can a startup that plans to raise venture capital be an S corporation?
Usually not for long. S corporations cannot have entity shareholders such as venture funds, cannot have nonresident alien shareholders and can have only one class of stock, so they cannot issue standard preferred stock. Most venture-backed companies form as or convert to Delaware C corporations before their first priced round.
What happens if I miss the Form 2553 deadline?
The election generally takes effect for the following tax year instead. The IRS also offers simplified late-election relief in many cases if the entity has reasonable cause and has acted consistently with S corporation status, so a missed deadline is often fixable if it is addressed promptly.
Do S corporation owners have to take a salary?
Shareholders who perform significant services for the company should receive reasonable compensation through payroll before taking distributions. Paying little or no salary while taking large distributions is a well-known audit issue, and the IRS can recharacterize distributions as wages subject to employment taxes.
How Sutter Law Can Help
We advise owners on business formation and entity choice, prepare operating and shareholder agreements that are consistent with S corporation rules, and work alongside your CPA on conversions and elections. Contact us for a free consultation.
This article is general information, not legal advice. Reading it does not create an attorney-client relationship.
