An S-corporation is a federal tax election, not a business entity, that lets a qualifying corporation or LLC pass its income, losses, deductions, and credits directly to its shareholders. The business itself generally pays no federal income tax; instead, owners report their share of the company’s activity on their personal returns and pay tax at individual rates. The legal structure of the underlying entity does not change, so shareholders keep the limited liability protection of a corporation or LLC while the profits are taxed only once.
You do not form an S-corporation at the state level. You first create a corporation or LLC, then file IRS Form 2553 to ask the IRS to treat it as an S-corp for tax purposes.
Who Can Qualify
The eligibility rules in Internal Revenue Code Section 1361 are strict, and a business must meet every one of them to make and keep the election.1Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined The entity must be a domestic corporation or an LLC that has elected corporate tax treatment. It can have no more than 100 shareholders, though a married couple and their estates count as one shareholder for that cap.
Ownership is restricted. Shareholders must be U.S. citizens or resident aliens; nonresident aliens cannot hold equity. Only individuals, certain estates, and specific qualifying trusts are permitted owners. Partnerships and other corporations cannot own shares in an S-corp.
The company can issue only one class of stock. Voting rights can differ between shares, but every share must carry the same rights to distributions and liquidation proceeds. Break any of these rules — admit an ineligible owner, create a second class of stock, cross the 100-shareholder line — and the IRS can automatically terminate the election.
How S-Corp Taxation Works
The defining feature is pass-through taxation. The corporation does not pay federal income tax on its profits.2Internal Revenue Service. S Corporations Profits, losses, deductions, and credits flow through to shareholders in proportion to their ownership, and each owner pays tax on that share at their personal rate. This avoids the double taxation that hits a C-corporation, where the company pays corporate income tax on profits and shareholders pay tax again on dividends.
Each year, the business files Form 1120-S, an information return that reports total activity and how it is allocated among the owners.3Internal Revenue Service. About Form 1120-S, U.S. Income Tax Return for an S Corporation Every shareholder receives a Schedule K-1 showing their individual portion of income, deductions, and credits, and reports those figures on their Form 1040. This happens whether or not the company actually distributed cash to them during the year. You can be taxed on income you never received.
There are narrow situations where an S-corp still pays entity-level tax, mostly involving companies that used to be C-corporations. Built-in gains on assets held at the time of conversion can be taxed at the corporate level if those assets are sold within five years of the switch.4Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains An S-corp with accumulated earnings and profits from its C-corp years can also owe corporate tax on excess passive investment income.
Salary and Distributions
The employment tax treatment of shareholder pay is the main reason most owners choose S-corp status. Any shareholder who works in the business must be paid a reasonable salary, reported on a W-2 and subject to standard employment taxes.5Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues The combined FICA rate is 15.3 percent, split evenly between the company and the employee. That breaks down to 12.4 percent for Social Security and 2.9 percent for Medicare.6Social Security Administration. Social Security and Medicare Tax Rates The Social Security portion applies only to wages up to $184,500 in 2026; the Medicare portion has no cap.7Social Security Administration. Contribution and Benefit Base
Any profit left after the salary can be distributed to shareholders. Those distributions are subject to income tax but not to FICA or self-employment tax. That is the core advantage: a sole proprietor or general partner pays self-employment tax on every dollar of business income, while an S-corp owner-employee pays employment taxes only on their salary.
The obvious temptation is to pay a small salary and take everything else as a distribution. The IRS looks closely at this. There is no fixed formula for a reasonable salary, but the agency weighs factors like the owner’s training and experience, duties, hours, what similar businesses pay for the same work, and the company’s overall performance.8Internal Revenue Service. Wage Compensation for S Corporation Officers If your salary is judged too low, the IRS can reclassify distributions as wages and assess back FICA taxes, interest, and penalties.
Making the Election
To become an S-corporation, you file Form 2553. The form asks for the company’s legal name, Employer Identification Number, date of incorporation or formation, and state of organization. You choose a tax year, which is normally the calendar year; a fiscal year is available only with a valid business purpose.9Internal Revenue Service. Instructions for Form 2553, Election by a Small Business Corporation
The form also requires a complete shareholder list with each owner’s name, address, Social Security number, share count, and acquisition date. Every shareholder has to sign, consenting to have the corporation’s income flow through to their personal return.10Internal Revenue Service. Form 2553, Election by a Small Business Corporation
Form 2553 must be filed no later than two months and 15 days after the beginning of the tax year you want the election to apply to, or at any time during the prior tax year. For a calendar-year business, that means March 15. You can file by mail, by fax, or as a PDF attached to a timely e-filed return.11Internal Revenue Service. Filing Requirements for Filing Status Change The IRS generally responds within about 60 days.12Internal Revenue Service. Instructions for Form 2553 Approval comes as a CP261 notice, which you should keep in your permanent records.
Missed the deadline? Revenue Procedure 2013-30 offers relief if the business intended to be an S-corp on the desired effective date, the late Form 2553 was the only thing wrong, you have reasonable cause for the delay, and you request relief within three years and 75 days of that effective date. All shareholders must have already reported income consistently with S-corp treatment.13Internal Revenue Service. Revenue Procedure 2013-30
Annual Filings
A calendar-year S-corporation files Form 1120-S by March 15 of the following year. Need more time? File Form 7004 by that same date to get an automatic six-month extension to September 15.14Internal Revenue Service. Instructions for Form 1120-S
Late-filing penalties are steep and scale with ownership. Even when no tax is due, the penalty is $255 per month or partial month, multiplied by the number of shareholders during any part of the tax year, for up to 12 months. A four-shareholder company filing six months late owes $6,120. Returns more than 60 days late face a minimum penalty equal to the lesser of the tax due or $525. Failing to furnish a timely, accurate Schedule K-1 to each shareholder brings a separate $340 penalty per K-1.
How the Election Can End
S-corp status can end voluntarily or involuntarily, and either way the business reverts to C-corporation taxation, with corporate-level tax on profits and potential double taxation on distributions.
To revoke the election, owners of more than 50 percent of outstanding shares — voting and non-voting combined — must consent in writing.15Internal Revenue Service. Revoking a Subchapter S Election A revocation filed on or before the 15th day of the third month of the tax year applies to the whole current year; filed later, it takes effect on the first day of the next year. You can also name a future effective date.16Office of the Law Revision Counsel. 26 USC 1362 – Election; Revocation; Termination
Involuntary termination happens automatically when the business trips an eligibility rule, such as passing 100 shareholders, admitting a nonresident alien, or issuing a second class of stock. It also happens when an S-corp with accumulated earnings and profits from prior C-corp years takes in more than 25 percent of its gross receipts from passive investment income for three consecutive tax years.
After a revocation or termination, the business generally cannot re-elect S-corp status for five tax years unless the IRS grants earlier permission. If a termination was inadvertent and quickly corrected, the IRS has discretion to treat the election as if it had never lapsed.
State Tax Treatment
The election is federal, and states do not all follow it. Most recognize the federal S-corp automatically, but some require a separate state-level filing for pass-through treatment, and a few, including the District of Columbia and Tennessee, do not recognize S-corp status at all and tax these businesses like regular corporations.
Even in states that honor the election, many charge some kind of entity-level tax: a minimum franchise tax, a gross receipts tax, or a flat annual fee. Some also tax S-corp income earned within their borders that flows to out-of-state shareholders. Check your state’s rules before assuming the federal pass-through eliminates every entity-level obligation.