S Corporation
Eligibility & Elections
Master the requirements, shareholder limits, and election process for S corporation status under IRC §1361 and §1362.
CPA Regulation (REG)
What Is an S Corporation?
An S corporation is a corporation that has elected a special tax status under Subchapter S of the Internal Revenue Code. It is not a separate entity type: it is a regular corporation that files Form 2553 to be taxed as a pass-through entity.
Why S Corp Status Matters
✓ Avoid Double Tax
C corps are taxed at entity level AND shareholder level. S corps are taxed once.
✓ Pass-Through Losses
Shareholders can deduct losses on their personal returns, subject to basis limitations.
✓ Self-Employment Savings
Distributions (beyond reasonable salary) are not subject to self-employment tax.
C Corp vs. S Corp Taxation
The Five Eligibility Requirements
1
Domestic corporation. Must be organized in the United States.
2
Eligible shareholders only. Individuals, estates, certain trusts, and certain tax-exempt organizations. No corporations, partnerships, or nonresident aliens.
3
Maximum 100 shareholders. Family members (up to 6 generations) may elect to count as one shareholder.
4
One class of stock. All outstanding shares must confer identical distribution and liquidation rights. Voting differences are allowed.
5
Not an ineligible corporation. Cannot be a bank using reserve method, insurance company, DISC, or certain financial institutions.
Who Can Be an S Corp Shareholder?
The 100-Shareholder Rule
An S corporation may have no more than 100 shareholders. But the counting rules have special exceptions that the CPA exam loves to test.
Family Election
Members of a family (and their spouses) within 6 generations of a common ancestor may elect to be treated as one shareholder.
Husband & Wife
A husband and wife (and their estates) are automatically treated as one shareholder, regardless of how they hold shares.
One Class of Stock Requirement
All outstanding shares must confer identical rights to distributions and liquidation proceeds. However, differences in voting rights alone do not create a second class of stock.
✓ Allowed
Voting shares and non-voting shares with equal economic rights. Same distribution per share.
✕ Not Allowed
Class A shares receive \( 2\times \) distributions per share vs. Class B. This creates a second class and disqualifies S status.
S Corp vs. Partnership
| S Corporation | Partnership | |
|---|---|---|
| Max Owners | 100 | Unlimited |
| Owner Types | Individuals, estates, certain trusts | Any entity or person |
| Classes of Equity | One class | Multiple classes |
| Special Allocations | Not permitted | Permitted |
| Entity-Level Tax | Generally none | Generally none |
| Basis from Debt | Shareholder loans only | Entity-level debt |
| Filing Form | Form 1120-S | Form 1065 |
Making the S Election: Form 2553
1
File Form 2553 with the IRS, signed by all shareholders who consent to the election.
2
Timing matters: File by the 15th day of the 3rd month of the tax year (March 15 for calendar-year corps) for the election to be effective for the current year.
3
Late elections: If filed after the deadline, the election is generally effective for the following tax year.
4
All shareholders must consent. Every shareholder on the date of election (and anyone who held shares during the year before the election date) must sign.
Election Timeline
Eligibility Checklist
1
Is it a domestic corporation? If organized under U.S. law, proceed. LLCs that elected corporate treatment also qualify.
2
Check each shareholder. Every owner must be an individual (U.S. citizen or resident), estate, or eligible trust. Flag any corporate, partnership, or NRA shareholders.
3
Count shareholders. Apply the family election rule and spouse rule. Total must not exceed 100.
4
Verify one class of stock. All shares must have identical distribution and liquidation rights. Voting differences alone are acceptable.
5
Confirm entity type. Ensure the corporation is not a bank (reserve method), insurance company, DISC, or other ineligible entity.
Example 1: Simple Eligibility
✓
Domestic corporation: Yes: organized in the U.S.
✓
Eligible shareholders: Yes: all individuals, all U.S. citizens.
✓
Shareholder count: \( 45 < 100 \). Passes.
✓
One class of stock: Yes: only common stock.
✓
Not ineligible: Yes: software company is not an excluded entity type.
Example 2: Tricky Shareholder
1
Domestic corporation: Yes.
2
Eligible shareholders: No! A partnership is not an eligible S corp shareholder.
3
Result: Beta Corp. is ineligible for S status as long as XYZ Partnership holds shares.
Example 3: Family Counting
Without Family Rule
\( 95 + 12 = \) 107 shareholders. Exceeds 100: ineligible.
With Family Election
\( 95 + 1 = \) 96 shareholders. Under 100: eligible!
Termination of S Status
Voluntary Revocation
Shareholders holding more than \( 50\% \) of the shares (voting and non-voting) must consent to revocation.
Ceasing to Qualify
If any eligibility requirement is violated (e.g., shares sold to a corporation), S status terminates automatically.
Excess Passive Income
If the S corp has C corp E&P and passive investment income exceeds 25% of gross receipts for 3 consecutive years, S status terminates.
Common Mistakes
✕ Ignoring NRA Rule
Even one nonresident alien shareholder disqualifies the entire S election. Always verify residency status.
✕ Confusing Voting with Class
Voting differences alone do NOT create a second class of stock. Only differences in economic rights (distributions/liquidation) matter.
✕ Missing the Filing Deadline
Filing Form 2553 even one day late (after the 15th day of the 3rd month) pushes the election to the next tax year.
Summary Reference Table
| Requirement | Rule | Key Detail |
|---|---|---|
| Entity Type | Domestic corporation | LLC can qualify if it elects corp treatment |
| Shareholders | Individuals, estates, certain trusts | No corps, partnerships, or NRAs |
| Max Shareholders | \( \leq 100 \) | Family = 1; spouses = 1 |
| Stock Classes | One class only | Voting differences are OK |
| Election Form | Form 2553 | Due by 15th day of 3rd month |
| Consent | 100% for election | \( >50\% \) for revocation |
| Re-election Wait | 5 years | Unless IRS grants consent |
Question 1 of 5
Which of the following is not an eligible shareholder of an S corporation?
A partnership cannot be an S corporation shareholder. Only individuals, estates, and certain trusts are eligible. Resident aliens (not nonresident aliens) are permitted as individual shareholders.
Question 2 of 5
A calendar-year corporation files Form 2553 on April 1 of the current year. When does the S election become effective?
For a calendar-year corporation, Form 2553 must be filed by March 15 to be effective for the current year. Since April 1 is after the deadline, the election takes effect on January 1 of the following year.
Question 3 of 5
An S corporation has two classes of stock: Class A (voting, receives \( \$2 \) per share in distributions) and Class B (non-voting, receives \( \$2 \) per share in distributions). Is this corporation eligible for S status?
Differences in voting rights alone do not create a second class of stock. As long as all shares have identical distribution and liquidation rights, the one-class-of-stock requirement is satisfied.
Question 4 of 5
A corporation wishes to revoke its S election. What percentage of shareholders must consent to the revocation?
Revocation requires consent from shareholders holding more than \( 50\% \) of all shares (both voting and non-voting). This is different from the election, which requires 100% shareholder consent.
Question 5 of 5
Corp Z has accumulated C corporation earnings and profits. For 3 consecutive years, its passive investment income exceeds 25% of gross receipts. What happens to its S status?
If an S corporation has accumulated C corporation E&P and passive investment income exceeds 25% of gross receipts for 3 consecutive years, the S election is automatically terminated. Note: this rule only applies if there are C corp E&P; without them, there is no termination.