An S corp is a federal tax status, not a type of company. When an eligible corporation or LLC files Form 2553 with the IRS under Subchapter S of the Internal Revenue Code, its profits, losses, deductions, and credits stop being taxed at the business level and instead flow through to the owners’ personal tax returns.1Office of the Law Revision Counsel. 26 USC Subtitle A, Chapter 1, Subchapter S – Tax Treatment of S Corporations and Their Shareholders In exchange for that pass-through treatment, the business has to meet strict ownership rules, pay working owners a reasonable salary, and keep up with annual filings that carry real penalties if missed.
Who Can Elect S Corp Status
Only a domestic corporation—one organized under the laws of a U.S. state or territory—can make the election.2Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined The business also has to satisfy each of the following conditions on the day it elects and every day afterward:
- No more than 100 shareholders. Family members going back up to six generations, plus spouses and former spouses, can be counted as a single shareholder.
- Shareholders must be individuals, certain estates, or qualifying trusts. Partnerships, other corporations, and nonresident aliens are not permitted.
- Only one class of stock. Voting rights can differ across shares, but rights to distributions and liquidation proceeds must be identical.
Break any of these rules, even briefly, and the S election terminates automatically. The business drops back to C corporation taxation, and getting the S status back generally means waiting five years. That is why vetting eligibility before adding a shareholder, moving stock into a trust, or restructuring shares matters so much.p>
How S Corp Taxation Works
An S corporation generally pays no federal income tax itself. The company files an information return, and each shareholder’s slice of income, losses, deductions, and credits is reported to them on a Schedule K-1 and picked up on their Form 1040.3Internal Revenue Service. Shareholder’s Instructions for Schedule K-1 (Form 1120-S)
Because the income is taxed on the personal return, it moves through individual brackets that run from 10 percent to 37 percent in 2026, rather than the flat 21 percent rate that applies to C corporations.4Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 20265Internal Revenue Service. Publication 542, Corporations For many small-business owners in lower brackets, or those who qualify for the qualified business income deduction, the pass-through structure ends up cheaper overall. For owners at the top of the rate schedule, the comparison is less obvious and depends on how much comes out as salary versus distribution.
C corporation earnings, by contrast, are taxed once at the corporate level and again when paid out as dividends. The S election eliminates that second layer.
The Salary Rule for Owner-Employees
Any shareholder who works for the S corporation has to be paid a reasonable salary through payroll as a W-2 employee. That salary is subject to FICA taxes: 6.2 percent for Social Security on wages up to $184,500 in 2026, and 1.45 percent for Medicare, paid by both the employee and the employer for a combined rate of 15.3 percent.6Social Security Administration. Contribution and Benefit Base7Internal Revenue Service. Self-Employment Tax (Social Security and Medicare Taxes) Higher earners owe an extra 0.9 percent Medicare tax on wages above $200,000 (single) or $250,000 (married filing jointly).
Profits paid out beyond that salary, as shareholder distributions, are not subject to self-employment tax. That gap is the main payroll-tax advantage of an S corporation compared to a sole proprietorship or partnership, where every dollar of net earnings faces self-employment tax.
The catch: the IRS looks closely at whether the salary is genuinely reasonable for the work performed. A salary set artificially low so the owner can pull more out as tax-free distributions invites reclassification, back payroll taxes, and penalties.8Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues The IRS weighs the owner’s training and experience, hours worked, duties, comparable pay for similar roles, dividend history, and how much of the company’s revenue is driven by the owner’s personal services rather than employees or capital. The more the business runs on the owner’s own labor, the more of its receipts the IRS expects to see paid as wages.
The 20 Percent QBI Deduction
Shareholders may deduct up to 20 percent of their qualified business income—the net income passed through from the S corporation, not counting salary—under Section 199A.9Internal Revenue Service. Qualified Business Income Deduction The One Big Beautiful Bill Act, signed August 5, 2025, made this deduction permanent. It is available whether you itemize or take the standard deduction.
For 2026, single filers with taxable income below $201,750 and joint filers below $403,500 get the full deduction. Above those thresholds, extra limits kick in based on the type of business, the W-2 wages it pays, and the basis of its physical assets. Specified service businesses such as law, medicine, consulting, and financial services face the tightest phase-out: the deduction disappears entirely for single filers above $276,750 and joint filers above $553,500. Overall, the deduction cannot exceed 20 percent of taxable income minus net capital gains.
When the S Corp Itself Owes Tax
Two situations pull tax back to the entity level.10Internal Revenue Service. S Corporations The first is the built-in gains tax, which hits companies that convert from C corporation to S corporation status. If the business sells assets that had appreciated before the conversion, the pre-conversion gain is taxed at 21 percent during a five-year recognition period starting with the first S corporation tax year.11Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains
The second is the excess net passive income tax. An S corporation carrying accumulated earnings and profits from a prior C corporation life faces this tax if more than 25 percent of its gross receipts come from passive sources like rents, royalties, dividends, and interest. Cross the 25 percent line for three consecutive years and the S election terminates automatically.12Office of the Law Revision Counsel. 26 USC 1362 – Election, Revocation, Termination A business built from scratch as an S corporation never has C corporation earnings and profits, so this tax does not apply.
How To Make the Election
The business first needs a federal Employer Identification Number. You can apply free through the IRS online portal and receive the EIN immediately, or submit Form SS-4 by mail (four to five weeks) or fax.13Internal Revenue Service. Instructions for Form SS-4 – Application for Employer Identification Number
The election itself is made on IRS Form 2553, which every shareholder must sign.14Internal Revenue Service. Instructions for Form 2553 The form asks for each shareholder’s name, address, taxpayer identification number, ownership percentage, and the date they acquired their shares, and it goes to the IRS service center for your state by mail or fax.
The deadline is tight: Form 2553 must be filed no more than two months and 15 days after the start of the tax year the election is to take effect. For a calendar-year business wanting S status effective January 1, that means March 15. You can also file the election any time during the preceding tax year.
The IRS generally rules within 60 days and mails a CP261 notice confirming the effective date.15Internal Revenue Service. CP261 Notice – We Have Accepted Your S Corporation Election Keep that notice permanently; you may be asked to prove the election was accepted years later.
Missed the deadline? Revenue Procedure 2013-30 offers late election relief if you can show reasonable cause, the business was otherwise eligible, and all shareholders have reported income consistently with S corporation treatment since the intended effective date.16Internal Revenue Service. Late Election Relief The request has to be filed within three years and 75 days of that intended date. Outside that window, the only path is a private letter ruling, which costs more and takes longer.17Internal Revenue Service. Revenue Procedure 2013-30
Ongoing Filing Obligations
Every S corporation files Form 1120-S each year, due by the 15th day of the third month after the tax year ends—March 15 for calendar-year filers.18Internal Revenue Service. Publication 509, Tax Calendars Form 7004 buys an automatic six-month extension to September 15. Each shareholder gets a Schedule K-1 showing their share of the year’s income, losses, deductions, and credits.
Because pass-through income has no withholding, shareholders generally need quarterly estimated payments if they expect to owe $1,000 or more at filing.19Internal Revenue Service. Estimated Taxes Use Form 1040-ES. The four due dates are April 15, June 15, September 15, and January 15 of the following year.
Filing 1120-S late costs $255 per shareholder per month (or partial month), for up to 12 months.20Internal Revenue Service. Instructions for Form 1120-S That penalty applies even when the entity owes no tax, so a four-shareholder company six months late is already looking at $6,120.
Losing or Ending S Corp Status
Shareholders holding more than half the stock can voluntarily revoke the election by filing a statement with the IRS.12Office of the Law Revision Counsel. 26 USC 1362 – Election, Revocation, Termination A revocation filed in the first two months and 15 days of the tax year applies to that entire year; filed later, it generally takes effect the following year unless a future date is specified.
The election also terminates automatically the moment the company breaks an eligibility rule. A nonresident alien inheriting stock, a corporate parent buying in, or a second class of stock with different economic rights all trip that wire. Once the S status is gone, whether by revocation or termination, the corporation generally cannot re-elect for five years without IRS consent.21eCFR. 26 CFR 1.1362-3 – Treatment of S Termination Year The IRS may waive that waiting period when the cause has been corrected and is unlikely to recur, but only through a formal request.
State Taxes Don’t Always Follow
The S election is federal. States are not obligated to honor it, and while most recognize the election and tax shareholders on their pass-through income, some impose their own entity-level income or franchise tax on S corporations, and at least one major city ignores the S election entirely and taxes the company as a C corporation. State annual report and franchise fees on the underlying entity vary from zero to several thousand dollars. Check your state’s rules before you file, because state-level taxes can shrink or wipe out the federal savings you were counting on.