S Corporation Election

An S corporation election allows an eligible domestic corporation to be taxed as a pass-through entity rather than as a C corporation, eliminating the entity-level income tax and the second layer of tax on distributions. The election is made on Form 2553 and requires the consent of all shareholders. Income, deductions, and credits flow through to shareholders on Schedule K-1 from Form 1120-S, and shareholders report their pro rata shares whether or not cash is distributed.

Eligibility is restrictive. The corporation may have no more than 100 shareholders, counting certain family members as one. Shareholders must be individuals, estates, or specific categories of trusts and tax-exempt organizations - partnerships, corporations, and nonresident aliens are ineligible. Only one class of stock is permitted, though differences in voting rights alone do not violate this rule. Certain financial institutions, insurance companies, and domestic international sales corporations cannot elect.

Timing is unforgiving in form but forgiving in practice: the election must be filed by the fifteenth day of the third month of the tax year for which it is to be effective, or at any time in the preceding year, though relief for late elections is routinely available under Rev. Proc. 2013-30 where reasonable cause exists.

The central planning issue is reasonable compensation. Because distributions to shareholder-employees are not subject to employment taxes while wages are, there is an incentive to minimize salary - an incentive the IRS actively challenges, with adjustments recharacterizing distributions as wages plus penalties and interest. Other recurring issues include the built-in gains tax for corporations that converted from C status, basis limitations on loss deductions, and inadvertent terminations from a prohibited shareholder or a second class of stock.