An S-corporation election is a federal tax choice, made under Subchapter S of the Internal Revenue Code, that lets a qualifying corporation or LLC pass its income, losses, deductions, and credits directly to its shareholders instead of paying corporate income tax at the entity level. For owners who meet the eligibility rules and follow the compliance requirements, the election can meaningfully reduce the overall tax bill, particularly by cutting self-employment tax on business profits distributed above a reasonable salary. It is not a separate type of business entity. It is a tax status layered onto a corporation or an LLC that has elected corporate treatment.
Who Can Elect S-Corp Status
The Internal Revenue Code sets structural limits that the business must satisfy the entire time the election is in effect, not just on the day it is filed. The entity must be a domestic corporation or an LLC that has elected corporate tax treatment, and it cannot have more than 100 shareholders.1Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined Every shareholder must be a U.S. citizen or resident alien individual, or one of the specific trust or estate types the statute allows. Nonresident aliens, partnerships, and most corporations cannot hold shares.
The corporation can have only one class of stock. Every share must carry identical rights to distributions and liquidation proceeds, though voting rights are allowed to differ. Some businesses are ineligible regardless of size, including financial institutions that use the reserve method for bad debts and insurance companies taxed under Subchapter L.1Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined Breaking any of these rules at any point during the year can terminate the election automatically, so any change in ownership or capital structure needs to be checked against them first.
How to Make the Election
A qualifying business elects S-corp treatment by filing IRS Form 2553, “Election by a Small Business Corporation.”2Internal Revenue Service. About Form 2553, Election by a Small Business Corporation The form asks for the corporation’s legal name, Employer Identification Number, date of incorporation, and the tax year the election should take effect. Every shareholder has to sign, and each signature block requires the shareholder’s name, address, Social Security number, ownership percentage, and the date they acquired their shares.3Internal Revenue Service. Form 2553 – Election by a Small Business Corporation A single missing signature will get the whole election rejected. The completed form goes to the applicable IRS Service Center by mail or fax.
When to File
Timing controls whether the election covers the current year or the next one. To take effect for the current tax year, Form 2553 must be filed no later than the 15th day of the third month of that year, which is March 15 for a calendar-year corporation. It can also be filed at any point during the preceding tax year.4Office of the Law Revision Counsel. 26 USC 1362 – Election; Revocation; Termination Filed later than that, the election doesn’t kick in until the following tax year.
Late Election Relief
Missing the deadline isn’t necessarily fatal. Under Revenue Procedure 2013-30, a corporation can request late election relief if it intended to be an S-corp from the desired effective date, the only failure was the late filing, and it has reasonable cause for the delay. The request has to be made within three years and 75 days of the intended effective date.5Internal Revenue Service. Revenue Procedure 2013-30 The corporation files a completed Form 2553 with “FILED PURSUANT TO REV. PROC. 2013-30” written across the top, along with a statement explaining the reasonable cause and the corrective steps taken. All shareholders during the relevant period must sign. The form can be attached to the current-year Form 1120-S or filed on its own.
How the Tax Savings Actually Work
The election’s core effect is that the corporation itself generally pays no federal income tax. Income, losses, deductions, and credits flow through to each shareholder’s individual return in proportion to ownership.6Office of the Law Revision Counsel. 26 USC 1366 – Pass-Thru of Items to Shareholders A 40% shareholder reports 40% of the year’s income on Form 1040, whether or not any money was actually distributed. That structure avoids the double layer of tax that hits C-corporation profits, which are taxed once at the corporate level and again when paid out as dividends.
The real draw is what happens on distributions. Self-employment tax runs 15.3% on earned income, split between 12.4% for Social Security and 2.9% for Medicare.7Internal Revenue Service. Self-Employment Tax (Social Security and Medicare Taxes) A sole proprietor or partner pays that on all business profits. An S-corp shareholder-employee pays payroll taxes only on the salary portion; distributions of remaining profit escape self-employment tax entirely. Over a year, that can save thousands. But the salary has to hold up under scrutiny.
The Reasonable Salary Catch
A shareholder-employee who works in the business has to pay themselves a salary that reflects fair market value for the work performed. This is where the IRS pushes back hardest on S-corporations. Pay too little and the agency can reclassify distributions as wages, then assess back payroll taxes, interest, and penalties.
The IRS weighs several factors when deciding whether compensation is reasonable:8Internal Revenue Service. Wage Compensation for S Corporation Officers
- Training and experience the shareholder-employee brings to the role
- Duties and responsibilities they actually carry out
- Time and effort devoted to the business
- What comparable businesses pay for similar services
- Whether the corporation pays large distributions but small salaries
- Whether formal compensation agreements exist and how pay is structured
There is no safe harbor number. An owner running every aspect of a business that generates $500,000 in profit cannot draw a $30,000 salary and pull the rest as distributions. That pattern is exactly what draws audits. Research salaries paid for comparable work in your industry, document the reasoning behind the figure you pick, and lean toward the defensible side.
Basis Limits on Losses
One of the more common surprises for new S-corp shareholders is finding out they cannot fully deduct their share of the corporation’s losses. Losses pass through only to the extent of your basis in the corporation, calculated by combining your stock basis with any direct loans you have made to the company.9Internal Revenue Service. S Corporation Stock and Debt Basis Guaranteeing a bank loan for the corporation does not create debt basis. A lot of shareholders assume it does; it doesn’t.
Stock basis adjusts each year in a set order: increased by income, then decreased by distributions, then reduced by non-deductible expenses, and finally reduced by deductible losses.9Internal Revenue Service. S Corporation Stock and Debt Basis Losses exceeding your combined stock and debt basis are not lost outright; they are suspended and carry forward indefinitely until you have enough basis to absorb them. But if you dispose of all your stock before using the suspended losses, they disappear.
Two more filters apply after the basis test. The at-risk rules limit deductions to the amount you personally have on the line, meaning cash or property you contributed plus amounts you personally borrowed for the activity. Then the passive activity rules can restrict losses further if you do not materially participate. Losses blocked by either rule carry forward.10Internal Revenue Service. Publication 925 – Passive Activity and At-Risk Rules The sequence matters: basis, then at-risk, then passive activity.
Watch-Outs for Former C-Corporations
Corporations that convert from C to S face two entity-level taxes that never touch a business that has been an S-corp from the start.
The first is the built-in gains tax. If the S-corporation sells assets that had appreciated before the conversion within five years of the election, the built-in gain is taxed at the corporate level at 21%, on top of the normal pass-through taxation to shareholders.11Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains12Office of the Law Revision Counsel. 26 USC 11 – Tax Imposed Only the gain existing at the time of conversion counts; gain accruing afterward is exempt. Net operating loss carryforwards from C-corp years can offset the tax. Corporations that have always been S-corps are not subject to it at all.
The second is the excess passive income tax. An S-corporation carrying over accumulated earnings and profits from C-corp years owes a 21% tax on excess net passive income if more than 25% of its gross receipts come from interest, dividends, rents, royalties, and similar passive sources.13Office of the Law Revision Counsel. 26 USC 1375 – Tax Imposed When Passive Investment Income of Corporation Having Accumulated Earnings and Profits Exceeds 25 Percent of Gross Receipts Cross the 25% threshold for three consecutive years and the S-corp election terminates automatically. Corporations that have never been C-corps and have no accumulated earnings and profits from prior years are unaffected.
What Happened to the 20% QBI Deduction
For tax years 2018 through 2025, S-corp shareholders could claim a deduction of up to 20% of their qualified business income under Section 199A, which lowered the effective rate on pass-through income considerably. That deduction expired on December 31, 2025, and Congress has not extended it as of this writing.14Internal Revenue Service. Qualified Business Income Deduction For 2026, plan without it unless new legislation is enacted. The expiration raises the effective tax rate on S-corp income and may shift the calculus for owners weighing S-corp status against other structures.
Staying Compliant Each Year
Every S-corporation files Form 1120-S, the U.S. Income Tax Return for an S Corporation, by the 15th day of the third month after its tax year ends. For calendar-year filers, that is March 15.15Internal Revenue Service. Publication 509 – Tax Calendars A six-month automatic extension to September 15 is available by filing Form 7004. The corporation must also issue each shareholder a Schedule K-1 showing their share of income, deductions, and credits by that same due date.16Internal Revenue Service. About Form 1120-S, U.S. Income Tax Return for an S Corporation Shareholders use those K-1s to complete their individual returns.
Most states also require annual reports to the secretary of state and annual fees or franchise taxes, ranging from under $100 to several hundred dollars. Some states impose their own entity-level taxes on S-corporations, which shrinks the federal tax advantage. Late state filings can trigger penalties or administrative dissolution, so a compliance calendar is worth keeping.
Corporate formalities protect the liability shield that made incorporating worthwhile to begin with. Hold annual shareholder and director meetings, keep minutes, put major decisions into written resolutions, and keep the corporation’s books and bank accounts separate from personal ones. Courts can pierce the corporate veil and hold shareholders personally liable for business debts when the corporation is treated as indistinguishable from its owners.
Ending the Election
An S-corp election can end in three ways: voluntary revocation, involuntary termination from a disqualifying event, or excess passive income for three consecutive years.
For a voluntary revocation, shareholders holding more than 50% of all issued and outstanding stock, voting and non-voting combined, file a revocation statement with the IRS.17Internal Revenue Service. Revoking a Subchapter S Election A revocation filed by the 15th day of the third month of the tax year, with no specified later date, takes effect retroactively to the start of that year. Filed after that, it takes effect at the start of the following year. Shareholders can also set a future effective date for a mid-year transition.4Office of the Law Revision Counsel. 26 USC 1362 – Election; Revocation; Termination
Involuntary termination happens the moment the corporation stops meeting any eligibility requirement, such as admitting a nonresident alien shareholder or crossing the 100-shareholder ceiling. When the failure was accidental, the IRS can grant relief under Section 1362(f) if the corporation shows the circumstances were inadvertent, took prompt corrective action, and all affected shareholders agree to any adjustments the IRS requires.18Internal Revenue Service. Revenue Procedure 98-55 That relief usually requires a private letter ruling, which carries significant fees and processing time. Certain trust-related terminations, such as a missed QSST or ESBT election, qualify for automatic relief under a streamlined process if fixed within 24 months.
Once an S-corp election is revoked or terminated, the corporation generally cannot re-elect S status for five years without IRS consent.4Office of the Law Revision Counsel. 26 USC 1362 – Election; Revocation; Termination Factor that waiting period into any decision to end the election voluntarily.