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About S Corporations (S Corps)

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I was looking at the terms/words the readers of this site were hitting the most and it seems to be discussions of Subchapter S-Corporation. A business form often used in start up companies. To cater to my viewers tastes and thirst for knowledge here is a general overview of Subchapter S Corporations to give you a little background on these business vehicles.

Subchapter S corporation was promulgated to enable small business to incorporate and avoid the double taxation normally imposed on corporate income as seen in a C corporation. In many ways the Subchapter S Corporation is treated as an incorporated partnership for income tax purposes only. This treatment allows profits and losses to “pass through” directly to shareholders. At the same time, shareholders are shielded from individual liability. While, there are no limits on the size of the corporation’s assets or income under Subchapter S, a business must comply with some detailed statutory and regulatory requirements. The main advantages and disadvantages of Subchapter S status are summarized as follows:


  1. Limitation on Shareholders’ liability of shareholders;
  2. Avoidance of double taxation normally imposed on corporate income;
  3. Easy transferability of shares;
  4. Pass through of losses to shareholders;
  5. Avoidance of taxes on unreasonable accumulations of income under per I.R.C. §531.
  6. Continuity; death of a shareholder does not require dissolution of the corporate organization.


  1. 25% limitation on “passive investment income” for three consecutive years;
  2. Number of shareholders limited to 100;
  3. Limitations on deductibility of losses to the sum of the shareholder’s basis in his stock and the indebtedness of the corporation to the shareholders;
  4. Unintended termination of Subchapter S status for violation of Subchapter S eligibility requirements;
  5. Technicality of tax treatment of Subchapter S corporations under the Internal Revenue Code.
  6. Restricted transferability of shares to preclude sales to a non-qualifying shareholder.
  7. State tax laws often do not provide for Subchapter S status.

Discussion About S Corps

An “S” corporation is advantageous when a business organization desires to pass through losses and to retain sound limited liability for its shareholders. It is often used in new businesses in which high net operating losses are initially expected.

A Subchapter S election allows shareholders to offset income on an individual level rather than at the corporate level. A Subchapter S election may become disadvantageous when the organization begins to earn significant income or if the organization will earn a substantial portion of its income from what are known as “passive investments” typically rents, dividends, interest or sales or exchanges of stocks. Where the corporation produces income, individual shareholders will be liable for their proportionate share of income taxes regardless of whether the income was actually distributed to the shareholders.

A Subchapter S corporation must make an election under I.R.C. § 1362 using form 2553. Once an election is made, the business will not be liable for taxes at the corporate level, except for certain capital gains taxes (I.R.C. § 1374). Again, income will be taxed to shareholders, with a few exceptions, even if it is not actually distributed.

Requirements to be an S Corp

The major requirements of a Subchapter S corporation (I.R.C. § 1361-1379) are highlighted below. An S corporation is a small business corporation for which a Subchapter S election is in effect for the taxable year. An election under Subchapter S can be made only by an eligible “small business corporation.”

Small Business Corporation

The corporation must be limited as to the maximum number of shareholders permitted, the type of person who is eligible to hold shares in the corporation, and the classes of stock allowed in the corporation. I.R.C. § 1361(b) (1).

Domestic Corporation

The corporation must be organized in the United States or under the laws of the United States or one of its territories.

Maximum of 100 Shareholders

The number of shareholders permitted is 100. In determining who is a shareholder, the general rule is that the beneficial owner of the stock must be deemed to be the shareholder. In general, each beneficial owner of jointly held property is considered a shareholder. Thus, property held in joint tenancy or tenancy-in-common is deemed owned by each tenant for purposes of computing the maximum number of shareholders. However, a husband and wife, and their estate, are treated as one shareholder.

Certain trusts are allowed to be shareholders of S corporations and the general rule is that the individual deemed to own the trust, the current income beneficiary, or the decedent’s estate are considered to be the shareholders.

Qualified Shareholders

Stock in a Subchapter S corporation must be held by qualified shareholders. Under the IRC only the following may be shareholders in a Subchapter S corporation: An individual who is not a non-resident alien, the estate of an individual in bankruptcy, a decedent’s estate, and certain trusts. Corporations and partnerships may not hold shares in an S corporation.

Eligible Corporations

Many types of businesses are explicitly excluded from the list of corporations eligible for S status. An S corporation may not be a subsidiary of another corporation or a member of an affiliated group of corporations. An S corporation also cannot be a bank, mutual savings and loan association or insurance company.

Very Important One Class of Stock

An S corporation may have only one class of stock outstanding. However, the corporation may have differences in voting rights among the shares of common stock, without losing its S status. However, all issued stock must be identical in terms of the shareholders’ interest in the profits and assets of the corporation.

Shareholder Loans

In certain cases, loans issued to shareholders may be considered a second class of stock which would disqualify the corporation from S corporation status. However, there is a statutory safe harbor for loans having no “equity characteristics.” This means that the debt must be a “straight debt,” or one which is an unconditional promise to pay on demand or on a specified date a certain sum of money. The interest rate and interest payment date cannot be contingent on profits, the borrower’s discretion, or other uncertain factors. Further, the loan cannot be convertible into stock and the creditor must be an individual, estate or a trust which would be eligible as a shareholder in an S corporation. A debt that does not meet these safe harbor criteria would be considered a second class of stock which would disqualify the corporation from Subchapter S status.


A Subchapter S election must be unanimously agreed to by the shareholders. A Subchapter S election is made by filing the appropriate form with the Internal Revenue Service and attaching a signed statement indicating consent by each of the shareholders n form 2553. As a general rule, beneficial owners should be treated as shareholders for consent purposes. Where stock is co-owned by spouses or owned as joint tenants or tenants-in-common, both parties must separately consent to the election.

Generally, a Subchapter S election becomes effective on the first day of the taxable year if made on or before the fifteenth day of the third month of the corporation’s taxable year. Thus, a Subchapter S election can be achieved retroactively if elected within 75 days of the first day of a taxable year. In order to receive this retroactive treatment, a corporation must meet the following two requirements: (1) qualify as a small business corporation on each day through the election date and (2) have unanimous shareholder consent. Otherwise, an election will not take effect until the first day of the following taxable year. This prevents pre-election allocation of income or loss to shareholders who are either ineligible to be S corporation shareholders or shareholders who did not consent to the election. Once a valid Subchapter S election is made, it remains in effect until revoked or terminated.


Revocation will occur when the majority of the shareholders consent to a termination of the S corporation election. Under the current rules, unanimous consent of all shareholders is not required. Unless otherwise specified, the revocation is retroactively effective on the first day of the taxable year, if the revocation is made on or before the fifteenth day of the third month of the taxable year. Otherwise, the revocation is effective on the first day of the following year. The revocation may provide for a prospective effective date, which is not the first day of the taxable year, in which case there will be a “split year.”

A revocation statement should include the numbers of voting and non-voting stock issued and stock outstanding at the time the election is made and the date that the revocation becomes effective. This must be accompanied by a consent statement which states the number of issued and outstanding, voting and non-voting stock, held by each shareholder who consents to the revocation. Each consenting shareholder needs to sign this statement.


The following events can cause termination of Subchapter S status:

  1. Exceeding the maximum number of shareholders;
  2. Issuance of a second class of stock (including debt classified as a second class of stock);
  3. Transfer of stock to an ineligible shareholder (e.g. a corporation, partnership or non-eligible trust);
  4. Acquisition by the corporation of 80% or more of another corporation’s stock (I.R.C. § 1361(a)(2));
  5. Commencing business operations prohibited by I.R.C. § 1361(b)(2) (e.g. operation of a bank or insurance company);
  6. Passive investment income exceeding 25% and Subchapter C profits and earnings for three consecutive years.

A Subchapter S election termination is effective on the date the corporation ceases to be eligible for the Subchapter S election and once a termination is effected, a new Subchapter S election will not be permitted for five (5) years.

If the termination is “inadvertent,” the I.R.S. has discretion under I.R.C. § 1362(f) to set aside the termination. This waiver will be granted if the corporation eliminates or corrects any causes for the termination, within “a reasonable period of time after discovery of the event resulting in such termination” and there is no tax avoidance from continued Subchapter S treatment.

Ask yourself if you really want to depend on the IRS’s good graces and discretion to reinstate your S-status.