S corporation status provides many of the tax benefits commonly associated with pass-through taxation while generally preserving the limited liability protection available to corporation shareholders under state law. An S corporation is not a separate type of legal entity. Rather, it is generally a corporation, or another eligible entity such as an LLC that has elected to be treated as a corporation for federal tax purposes, that has made an election to be taxed under Subchapter S of the Internal Revenue Code.
Like a C corporation, an S corporation is generally a separate legal entity under the laws of the state in which it is organized. Under state law, shareholders of an S corporation are generally afforded the same liability protection as shareholders of a C corporation. For federal income tax purposes, however, an S corporation is generally treated as a pass-through entity. Income, deductions, losses, and credits generally pass through to the shareholders and are reported on the shareholders’ individual tax returns, whether or not distributions are made.
As a result, S corporation income is generally taxed at the shareholder level rather than at both the corporate and shareholder levels. Distributions to shareholders may be tax-free to the extent they represent income that was previously taxed to the shareholders, although additional rules and limitations may apply. Certain corporate-level taxes, such as the accumulated earnings tax and personal holding company tax, generally do not apply to S corporations.
To qualify for S corporation status, the entity generally must meet the following requirements:
- It must be a domestic corporation or another eligible domestic entity that is treated as a corporation for federal tax purposes.
- It must have no more than 100 shareholders.
- It must have only one class of stock.
- Its shareholders must be eligible shareholders, which generally include individuals who are U.S. citizens or residents, certain trusts, estates, and certain exempt organizations.
- It generally may not have partnerships, corporations, or nonresident aliens as shareholders.
- It must not be an ineligible corporation, such as certain financial institutions, insurance companies, or domestic international sales corporations.
To elect S corporation tax treatment, the corporation or eligible entity must file Form 2553, Election by a Small Business Corporation, with the Internal Revenue Service. Form 2553 must generally be signed by all shareholders. If a shareholder resides in a community property state, the shareholder’s spouse may also be required to sign.
The S corporation election generally must be filed no later than 2 months and 15 days after the beginning of the tax year for which the election is intended to be effective, or at any time during the preceding tax year. Late-election relief may be available if the entity meets IRS requirements and can show reasonable cause for the late filing.
State tax treatment may differ from federal tax treatment. For example, New York requires a federal S corporation to file Form CT-6 to elect New York S corporation treatment. New Jersey generally recognizes a federal S corporation election for New Jersey purposes, subject to applicable state rules and opt-out procedures. Because state requirements vary, each state’s rules should be reviewed separately.
If an S corporation ceases to meet the applicable eligibility requirements, such as by having more than 100 shareholders or by transferring shares to an ineligible shareholder, its S corporation status may terminate. In that case, the corporation may be taxed as a C corporation unless relief or corrective action is available.
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