An S corporation is a corporation that meets a fixed set of eligibility limits in the Internal Revenue Code and has a valid election in effect to be taxed under subchapter S. It generally pays no income tax of its own. Its income, deductions, losses and credits are reported instead to its shareholders in pro rata shares and taxed once, on their own returns, whether or not the corporation distributes any cash.
The Two-Part Test in the Code
Both halves have to be true in the same year, and the statute puts them in one sentence. For purposes of this title the term S corporation means, with respect to any taxable year, a small business corporation for which an election under section 1362(a) is in effect for such year (26 U.S.C. 1361(a)(1)).
Small business corporation is itself a defined term, and it carries no revenue, asset or employee headcount test. It means a domestic corporation which is not an ineligible corporation and which does not have more than 100 shareholders, does not have as a shareholder a person, other than an estate, a permitted trust or a permitted exempt organization, who is not an individual, does not have a nonresident alien as a shareholder, and does not have more than 1 class of stock (26 U.S.C. 1361(b)(1)).
Size is not the line anywhere in that list. Substantial revenue does not disqualify a corporation with two individual shareholders, while a young company with a venture fund on its cap table is out on the shareholder test alone, because a fund is a person that is not an individual. The full eligibility walkthrough, the ineligible corporation list and the counting rules that soften the limits are set out in c corp vs s corp.
The second half is the election, and consent has to be unanimous. Except as provided in subsection (g), a small business corporation may elect to be an S corporation, and the election is valid only if all persons who are shareholders on the day the election is made consent to it (26 U.S.C. 1362(a)).
The consent list also reaches back inside the year. Where an election is made for a taxable year during that same year and on or before the 15th day of its 3d month, and 1 or more of the persons who held stock in the corporation during that year before the election was made did not consent to the election, the election is treated as made for the following taxable year instead (26 U.S.C. 1362(b)(2)). A shareholder who sold out earlier in the year is therefore still on the consent list.
S status is reached by election rather than by formation, and the form that carries the election, the window it runs on and the relief available when it is late or defective are in how to file a business tax return.
What the Election Changes
Except as otherwise provided in the subchapter, an S corporation is not subject to the taxes imposed by chapter 1 (26 U.S.C. 1363(a)). That opening phrase is doing real work, and the entity-level taxes it preserves are set out in federal income tax liability.
What the corporation does not pay, the shareholders do. In determining a shareholder’s tax there is taken into account the shareholder’s pro rata share of the corporation’s items of income, loss, deduction or credit whose separate treatment could affect the tax liability of any shareholder, and of its nonseparately computed income or loss (26 U.S.C. 1366(a)(1)). That provision is what places an S corporation in the class described in pass-through entities.
A shareholder’s share can also feed that shareholder’s own deduction for qualified business income, which is allowed to a taxpayer other than a corporation (26 U.S.C. 199A(a)) and is set out in QBI deduction.
Where an S Corporation Shows Up in a Firm’s Work
Two files, with one set of numbers moving between them. Use Form 1120-S to report the income, gains, losses, deductions, credits and other information of a domestic corporation or other entity for any tax year covered by an election to be an S corporation (IRS, Instructions for Form 1120-S).
The shareholder’s copy is the second file. Schedule K-1 shows each shareholder’s separate share, a copy of each one is attached to the Form 1120-S filed with the IRS, and each shareholder is given a copy (IRS, Instructions for Form 1120-S).
Distribution timing does not change the answer. Shareholders must include their share of the income on their tax return whether or not it is distributed to them, and unlike most partnership income, S corporation income is not self-employment income and is not subject to self-employment tax (IRS, Instructions for Form 1120-S). The shareholder’s tax follows the pro rata share, not the distribution.
One duty sits ahead of any of those distributions. S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee (IRS, S corporation compensation and medical insurance issues). What that standard costs a shareholder-employee whose salary runs through payroll is worked through in c corp vs s corp.
An S Corporation Is a Classification, Not a Way of Forming a Company
Nothing is incorporated by the election. The entity already exists under the statute it was organized under, and the election under 26 U.S.C. 1362(a) changes only how the federal return treats what that entity earns.
Common Questions
S corp is shorthand for S corporation, and the S names the subchapter. The rules sit in subchapter S of chapter 1 of the Internal Revenue Code, titled Tax Treatment of S Corporations and Their Shareholders (26 U.S. Code Subchapter S). The label says where a corporation is taxed in the Code, and nothing about what it sells.
The Code defines one against the other. A C corporation means, with respect to any taxable year, a corporation which is not an S corporation for that year (26 U.S.C. 1361(a)(2)). What separates them is where the tax is imposed and whether profit is taxed a second time when it leaves the company. The rates, that second layer and a worked comparison are in c corp vs s corp.
The two are not alternatives on one list. An LLC is a state-law form, and the same LLC can be treated as a partnership, as a disregarded entity, as a C corporation or as an S corporation for federal tax purposes. What actually gets settled is whether the entity clears the small business corporation limits, and then whether an election is in effect for the year.
No, and the definition rather than the business is the reason. A small business corporation may not have more than 100 shareholders and may not have a shareholder that is not an individual, with narrow exceptions (26 U.S.C. 1361(b)(1)). Public company ownership fails both limits, so S status belongs to closely held corporations rather than listed ones.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can hand a real block of its own S corporation return work to a trial task before any client file depends on it.
