What Is a Subchapter S Corporation: Eligibility, Taxes, Election

A Subchapter S corporation is a regular corporation that has elected a special federal tax status under Subchapter S of the Internal Revenue Code, so its profits, losses, deductions, and credits pass through to shareholders and are taxed on their personal returns instead of at the corporate level. That single election is what separates an S corp from a standard C corporation, which pays the 21% federal corporate income tax and whose shareholders are then taxed again on dividends. To use it, the business has to meet a strict set of eligibility rules and every shareholder has to consent by filing IRS Form 2553.

Who Can Elect S Corp Status

Internal Revenue Code Section 1361(b) sets out the conditions the corporation must meet, both when it makes the election and for as long as the election stays in effect.¹

It must be a domestic corporation, organized under the laws of a U.S. state or territory.
It cannot have more than 100 shareholders. Spouses and members of the same family, up to six generations from a common ancestor, count as a single shareholder.
Shareholders must generally be U.S. citizens or resident individuals, certain trusts, or estates. Partnerships, other corporations, and nonresident aliens cannot own shares.²
It can have only one class of stock. Differences in voting rights are allowed, but any variation in economic rights (distributions or liquidation proceeds) disqualifies the corporation.
It cannot be an ineligible corporation. Financial institutions using the reserve method of accounting for bad debts, insurance companies taxed under Subchapter L, and domestic international sales corporations (DISCs) are barred entirely.¹

Breaking any of these rules, even briefly, can end the election automatically. That’s why ownership changes and stock transactions need to be watched closely throughout the life of the business.

LLCs Can Elect Too

A limited liability company can elect S corp taxation without converting into a corporation under state law. The LLC simply files Form 2553.³ Once the election takes effect, the LLC files Form 1120-S each year and follows S corporation tax rules while keeping its LLC legal structure and state-law liability protections.⁴

How S Corp Income Is Taxed

The S corporation itself pays no federal income tax on its ordinary earnings. It files Form 1120-S as an informational return, and its income, losses, deductions, and credits flow through to shareholders in proportion to their ownership. Each shareholder receives a Schedule K-1 reporting their allocated share and reports those amounts on their personal Form 1040, where they’re taxed at individual rates.⁵

One point catches new S corp owners by surprise: shareholders owe tax on their allocated share of income whether or not the corporation actually distributes cash to them that year.²

The Built-In Gains Exception

A C corporation that converts to S status can still owe corporate-level tax on appreciation that existed in its assets at the time of conversion. This built-in gains tax applies during a five-year recognition period beginning with the first S corp year, calculated at the highest corporate rate (currently 21%).⁶ After the five years, it no longer applies. Corporations formed as S corps from the start are never subject to it.

The Reasonable Salary Rule

The largest practical payroll-tax benefit of an S corp is the split between wages and distributions. A shareholder who works in the business receives a salary subject to Social Security and Medicare taxes, and can take additional profits as distributions that are not subject to those taxes. A sole proprietor or general partner, by contrast, pays self-employment tax on the entire net income of the business.

The IRS requires the salary portion to be reasonable before any distributions are taken. There is no formula in the tax code. The IRS and courts look at the shareholder’s training and experience, duties and responsibilities, time devoted to the business, comparable pay for similar work, and the corporation’s dividend history.⁷ Setting the salary artificially low to shrink payroll taxes is one of the most common S corp audit triggers, and the IRS can reclassify distributions as wages and assess back taxes and penalties.

Deductions Shareholders Should Know

The Qualified Business Income Deduction

S corp shareholders may claim the Section 199A qualified business income deduction, worth up to 20% of qualified business income from the pass-through entity.⁸ It was originally scheduled to expire after December 31, 2025, but was made permanent by the One Big Beautiful Bill Act. The 20% calculation is unchanged.

Reasonable compensation reported on the shareholder’s W-2 is excluded from QBI; only the pass-through income shown on Schedule K-1 counts.⁸ For higher-income taxpayers, the deduction may be further limited based on the type of business and the W-2 wages the corporation pays.

Health Insurance for More-Than-2% Shareholders

A shareholder who owns more than 2% of the corporation and works in the business can deduct health insurance premiums as an above-the-line deduction on the personal return. To qualify, the S corporation must pay the premiums directly or reimburse the shareholder, and the premiums must be reported as taxable wages on the shareholder’s W-2.⁹

The deduction is not available if the shareholder or their spouse is eligible for a subsidized health plan through another employer. Buying coverage personally and paying out of pocket, without running it through the corporation’s payroll, also disqualifies the above-the-line deduction.⁹

Loss Deductions Are Capped by Basis

Shareholders can use S corp losses to offset other income, but only up to their basis in the corporation. Basis has two parts: the adjusted basis in the shareholder’s stock and the adjusted basis of any loans the shareholder has personally made to the corporation.¹⁰ Losses above combined stock and debt basis are not deductible in the current year, but they carry forward indefinitely and can be used when basis is later restored, such as through additional capital contributions or new shareholder loans. The at-risk rules of Section 465 and the passive activity loss rules of Section 469 can restrict deductions even when basis is sufficient.

Making the S Corp Election

The election is made by filing IRS Form 2553, “Election by a Small Business Corporation.”¹¹ The form asks for the corporation’s legal name, EIN, date of incorporation, state of formation, the chosen tax year, and each shareholder’s identifying information, share count, and acquisition date. Every shareholder must sign to show unanimous consent; a missing signature is grounds for rejection.

Filing Deadline

Form 2553 is due no later than two months and 15 days after the start of the tax year the election is meant to cover. It can also be filed any time during the preceding tax year.¹² For a calendar-year corporation seeking S status for 2026, the deadline is March 15, 2026. File by certified mail with return receipt requested, or by fax to the appropriate IRS service center, and keep the receipt as proof of timely filing.

Confirmation and Late-Filing Relief

The IRS confirms acceptance by issuing a CP261 notice, typically within about 60 days.¹³ If nothing arrives within two months, call the IRS at 1-800-829-4933.¹²

When a corporation misses the deadline, the election normally slips to the following tax year. Revenue Procedure 2013-30 allows late-filing relief if the corporation shows reasonable cause for the delay, all shareholders and the corporation reported income consistently with S status, and fewer than three years and 75 days have passed since the intended effective date.¹⁴ No private letter ruling and no user fee are required.¹⁵

Annual Filing Once the Election Is In Place

The corporation files Form 1120-S by the 15th day of the third month after the end of its tax year. For a calendar-year filer, that’s March 15.¹⁶ Form 7004 buys an automatic six-month extension, moving the deadline to September 15 for calendar-year corporations.

Along with Form 1120-S, the corporation prepares a Schedule K-1 for each shareholder showing their allocated income, losses, deductions, and credits.² Shareholders use their K-1 to complete Schedule E of the Form 1040. Payroll tax filings and deposits are also required for any shareholder-employees drawing wages.

How the Election Ends

S status can end involuntarily by violating an eligibility rule, or voluntarily by a shareholder vote.

Involuntary Termination

The election terminates the moment the corporation stops meeting any eligibility requirement. Common triggers include admitting an ineligible shareholder such as a nonresident alien or another corporation, crossing the 100-shareholder limit, or creating a second class of stock with different economic rights.¹

A separate rule targets S corporations that carry accumulated earnings and profits from a prior C corp existence. If more than 25% of gross receipts come from passive investment income (royalties, rents, dividends, interest, annuities) for three consecutive tax years while accumulated earnings and profits are still on the books, the S election ends at the start of the next tax year.¹⁷ An entity-level tax also applies in any single year the 25% threshold is crossed.¹⁸

Voluntary Revocation

Shareholders can revoke S status without unanimity. Holders of more than 50% of all outstanding shares (voting and nonvoting combined) must sign a revocation statement and submit it to the IRS.¹⁹ A revocation filed by the 15th day of the third month of the tax year takes effect on the first day of that year; otherwise it takes effect on the specified date or the following tax year.

The Five-Year Waiting Period

After either an involuntary termination or a voluntary revocation, the corporation generally cannot re-elect S status for five tax years unless the IRS grants earlier permission.¹⁷ Accidental violations can be expensive, so monitoring the eligibility rules matters.

State Tax Treatment Varies

The Subchapter S election is federal. State treatment is not uniform. Most states follow the federal election and tax the income only at the shareholder level, but several states impose their own entity-level taxes on S corporations or do not fully recognize the federal election. A handful charge a franchise tax, a minimum tax, or a percentage-based tax on S corp net income in addition to taxing shareholders. If the business operates in more than one state, check each state’s treatment before electing, because the state layer can meaningfully change the math.

1
Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined
2
Internal Revenue Service. S Corporations
3
Internal Revenue Service. About Form 2553, Election by a Small Business Corporation
4
Internal Revenue Service. LLC Filing as a Corporation or Partnership
5
Internal Revenue Service. Topic No. 407, Business Income
6
Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains
7
Internal Revenue Service. Wage Compensation for S Corporation Officers
8
Internal Revenue Service. Qualified Business Income Deduction
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Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues
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Office of the Law Revision Counsel. 26 USC 1366 – Pass-Thru of Items to Shareholders
11
Internal Revenue Service. Form 2553 – Election by a Small Business Corporation
12
Internal Revenue Service. Instructions for Form 2553
13
Internal Revenue Service. Understanding Your CP261 Notice
14
Internal Revenue Service. Late Election Relief
15
Internal Revenue Service. Rev. Proc. 2013-30
16
Internal Revenue Service. Publication 509, Tax Calendars
17
Office of the Law Revision Counsel. 26 USC 1362 – Election, Revocation, Termination
18
Office of the Law Revision Counsel. 26 USC 1375 – Tax Imposed When Passive Investment Income Exceeds 25 Percent of Gross Receipts
19
Internal Revenue Service. Revoking a Subchapter S Election