An S corp election, made on IRS Form 2553, allows an eligible corporation or LLC to be taxed under Subchapter S, so that income, deductions and credits generally pass through to shareholders rather than being taxed at the corporate level. The business then files Form 1120-S each year and issues Schedule K-1 to shareholders. Working shareholders must be paid reasonable wages through payroll.

Who Is Eligible?

According to the IRS Form 2553 instructions, an S corporation must generally:

• Be a domestic corporation, or an eligible entity (such as an LLC) that elects to be treated as a corporation
• Have no more than 100 shareholders (family members can be treated as one shareholder)
• Have only eligible shareholders: individuals, estates, certain trusts and certain exempt organisations; no partnerships, corporations or nonresident alien shareholders
• Have only one class of stock (differences in voting rights alone are allowed)
• Not be an ineligible corporation, such as certain banks, insurance companies or DISCs
• Have or adopt a permitted tax year

All shareholders must consent to the election. Foreign-owned businesses usually cannot elect, because nonresident aliens are not eligible shareholders.

Advantages of an S Corp Election

1. Possible Self-Employment Tax Savings

In an LLC taxed as a partnership or sole proprietorship, a working owner’s share of business profit is generally subject to self-employment tax. In an S corporation, the owner-employee is paid a salary subject to payroll taxes, and remaining profits distributed as S corporation income are generally not subject to self-employment or payroll tax. This is the main reason owners consider the election. The saving depends entirely on paying a reasonable salary first.

2. Pass-Through Taxation

Like a partnership, an S corporation generally does not pay federal income tax at the entity level, avoiding the double taxation that applies to C corporation dividends. Certain entity-level taxes, such as built-in gains tax, can still apply in specific situations.

3. Familiar Corporate Structure

Some owners and lenders prefer the clarity of shares and a corporate payroll structure, and shares can be transferred to eligible shareholders without restructuring.

Disadvantages and Trade-Offs

1. Reasonable Compensation and Payroll

Shareholders who work in the business must receive reasonable wages before taking distributions. That means running payroll, withholding taxes, filing quarterly payroll returns and issuing Forms W-2. Underpaying salary to maximise distributions is a common IRS audit issue. See our guide to payroll outsourcing for US businesses.

2. Rigid Ownership and Allocation Rules

Income must be allocated pro rata by shares owned, so the special allocations a partnership can make are not available. Distributions must also be proportionate, or the corporation risks being treated as having a second class of stock, which can terminate the election.

3. Limits on Investors

The 100-shareholder limit, the ban on corporate, partnership and nonresident alien shareholders, and the one-class-of-stock rule make S corporations a poor fit for venture capital or foreign investment.

4. Additional Costs and Complexity

Payroll processing, Form 1120-S preparation, shareholder basis tracking and state filings add costs that can outweigh the savings at lower profit levels.

5. State Treatment Varies

Not every state or city treats S corporations the same way as the federal government. Some impose entity-level taxes or fees, and some local jurisdictions do not recognise the election at all. Check the rules in every state where you operate.

6. Fringe Benefits for 2% Shareholders

Certain fringe benefits, such as health insurance premiums paid for shareholders owning more than 2%, are treated differently from those for regular employees and must be reported through payroll.

S Corp vs LLC Taxed as a Partnership: At a Glance

Swipe the table sideways to see all columns.

For a fuller comparison, see our article on Form 1065 vs Form 1120-S.

Illustrative Example

How to Make the Election: Form 2553

1. Confirm eligibility for the corporation and every shareholder.
2. Decide the effective date, usually the start of a tax year.
3. File Form 2553 no more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the preceding tax year.
4. Obtain every shareholder’s consent on the form.
5. For an LLC, a timely Form 2553 also serves as the election to be treated as a corporation, so a separate Form 8832 is generally not needed.
6. Keep the IRS acceptance letter; you will need it to prove the election.
7. Set up payroll for working shareholders from the effective date.

If the deadline is missed, Rev. Proc. 2013-30 may provide relief for a late election where there is reasonable cause, generally within 3 years and 75 days of the intended effective date. Relief is not automatic.

Tax Filing Impact After the Election

Swipe the table sideways to see all columns.

Revoking or Losing S Status

• Voluntary revocation requires the consent of shareholders holding more than half of the shares. A revocation made by the 15th day of the 3rd month of the tax year can take effect for that year; otherwise it generally takes effect the next year, unless a later date is specified.
• Termination happens automatically if the corporation stops qualifying, for example by admitting an ineligible shareholder or creating a second class of stock.
• Five-year wait: after revocation or termination, the corporation generally cannot re-elect S status for five tax years without IRS consent.

A C corporation that converts to S status may also face built-in gains tax on appreciated assets sold during a recognition period after conversion, so conversions should be planned carefully.

Frequently Asked Questions

Run the Numbers Before You Elect

An S corp election is a tool, not an automatic tax saving. Confirm eligibility, set a defensible salary, compare the savings with payroll and compliance costs, check state rules and consider your future investors before filing Form 2553.

This article provides general information and is not individualized tax advice. Tax rules and state treatment change; consult a qualified tax professional before making an election.

IRS sources: Instructions for Form 2553 · Instructions for Form 1120-S · IRS: S Corporations