S Corporations (2025)

S Corp Eligibility

• Domestic corporation only (no foreign entities)
• ≤100 shareholders (family members + estates can elect to count as ONE; family = common ancestor + lineal descendants + spouses/former spouses)
• Shareholders: US citizens/residents only (no nonresident aliens); certain trusts, estates, and tax-exempt organizations (§501(c)(3)) can be shareholders; corporations and partnerships generally CANNOT
• One class of stock only (voting rights can differ but must have identical distribution/liquidation rights)
• File Form 2553 (election):
  • New entity: within 2 months + 15 days of formation
  • Existing entity: any time in prior tax year, or by 15th day of 3rd month of election year (typically March 15)
  • All shareholders who held stock at any time before election must consent (even if since sold shares)
• Late election relief: Rev. Proc. 2013-30 — if entity intended S status, reasonable cause for lateness, all shareholders reported consistently, and <3 years + 75 days since effective date. Write "FILED PURSUANT TO REV.PROC.2013-30" on Form 2553

Entities That Cannot Be S Corps

Banks/savings institutions using reserve method for bad debts, insurance companies, DISCs, foreign entities.

S Corp Taxation

• Pass-through (like partnership) — no entity-level federal tax
• Form 1120-S due March 15 (3rd month after year-end); extension to Sept 15 (Form 7004, 6 months)
• Schedule K-1 to each shareholder
• Some states impose entity-level tax on S corps
• Income/loss allocated by shares held each day of tax year (pro-rata)
• Electronic filing: Required if filing 10+ returns of any type
• 2025 late filing penalty: $255/month per shareholder, max 12 months

Built-In Gains Tax (§1374)

If S corp was formerly a C corp: 21% tax on net unrealized appreciation at conversion date, recognized when assets sold within 5 years of conversion. Only applies to C-corp-to-S-corp conversions. Valuation at conversion date determines built-in gain.

Passive Investment Income Tax (§1375)

If S corp has accumulated E&P from C corp years AND passive investment income >25% of gross receipts: excess passive income taxed at 21%. If >25% for 3 consecutive years → S election TERMINATED. Passive income = royalties, rents, dividends, interest, annuities, securities sales gains.

Other Entity-Level Taxes (former C corps only)

• LIFO recapture: If C corp used LIFO and converts to S-corp → must recapture LIFO reserve into income over 4 years
• Investment credit recapture: Recapture of pre-S-election investment credit

Shareholder Basis

Stock Basis

• Initial: purchase cost, or §351 transfer basis (cash + property basis + gain − boot − liabilities assumed), or C-corp conversion basis (C-corp stock basis at conversion)
• Gifts: donor's basis (suspended passive losses may increase)
• Inheritance: FMV at date of death (or alternative valuation date)
• Services: FMV of stock (not services value)

Basis Adjustment Order (at year-end)

1. Increase: income items and excess depletion
2. Decrease: distributions
3. Decrease: non-deductible non-capital expenses
4. Decrease: loss and deduction items

Debt Basis

• Loans FROM shareholder TO S corp (directly, not guarantees) create debt basis
• Allows deducting losses beyond stock basis
• Only lending shareholder gets debt basis; other shareholders do NOT
• Third-party loans/guarantees do NOT create debt basis
• Repayment of debt basis → taxable to shareholder
• Form 7203: S Corp Shareholder Stock and Debt Basis Limitations — must file if claiming losses, receiving distributions, disposing stock, or receiving loan repayments. IRS recommends all shareholders file annually.

Distributions

• Tax-free to extent of stock basis (AAA account)
• Above stock basis → capital gain (Schedule D)
• Must be pro-rata to all shareholders at same date
• S corp distributing appreciated property: treated as sale → S corp recognizes gain (FMV − adjusted basis). Gain passes through to shareholders, increasing their basis. Loss NOT recognized on property distributions.
• Distributions from C-corp E&P → taxable dividends

Accumulated Adjustments Account (AAA)

• AAA = cumulative S-corp income less distributions, adjusted
• Distribution ordering: AAA → E&P (from C-corp years, = taxable dividend) → return of capital (reduce stock basis) → capital gain
• S corps without accumulated E&P: distributions are return of capital (reduce basis), then capital gain

Reasonable Compensation

S corp MUST pay reasonable salary to shareholder-employees BEFORE distributions. IRS aggressively audits unreasonably low salaries (evading FICA).

Factors (court-tested): training and experience, duties/responsibilities, time/effort in business, pay to non-shareholder employees, timing/method of bonuses to key personnel, comparable company wages, formal compensation agreements, compensation formulas.

Exception: Officers performing insignificant services or no services → not treated as employees (IRS regulation exception).

§199A QBI Deduction

S corp shareholders qualify for 20% QBI deduction.

• Shareholder-employee's reasonable compensation (wages) is EXCLUDED from QBI (like employee wages)
• But S corp's total W-2 wages (including wages paid to shareholders) COUNT for the wage/property limitation
• Distributions do NOT count as wages for §199A
• Example: $90K business income, $50K reasonable salary → $40K K-1 income = QBI. Tentative QBI deduction = 20% × $40K = $8K

Health Insurance for >2% Shareholders

• 2%+ shareholders: premiums paid by S corp = taxable wages (included in W-2 Box 1, subject to income tax withholding)
• BUT excluded from Social Security, Medicare, and FUTA wages
• Shareholder can deduct 100% above-the-line on personal 1040 (Schedule 1, Form 7206) — if coverage established by S corp
• Coverage can be "established by S corp" even if policy in shareholder's name, IF S corp pays/reimburses premiums and reports on W-2
• Cannot use Schedule K-1 or Form 1099 as W-2 substitute
• Cannot deduct if eligible for another employer's (or spouse's) subsidized health plan — even if declined

Separately Stated Items

Must be separately stated on K-1: rental real estate income/loss, portfolio income/loss (interest, dividends, royalties), capital gains/losses, §1231 gains/losses, charitable contributions, §179 expense, foreign taxes, business credits, investment interest expense, AMT preference/adjustment items, non-business bad debts. S corps do NOT get DRD.

Termination of S Status

Automatic Termination

• Ceasing to qualify (ineligible shareholder, >100 shareholders, second class of stock)
• 3 consecutive years of excess passive income (>25%) with accumulated E&P
• Voluntary revocation

Revocation

• Shareholders owning >50% (including non-voting stock) must consent
• File signed revocation statement with IRS (no specific form)
• Effective date: specified date (on/after filing date), OR if no date specified: Jan 1 if revoked by March 15, else next Jan 1
• Can be withdrawn before effective date

Post-Termination

• If S election terminates mid-year → two short tax years (S-corp short year + C-corp short year)
• Income/loss allocated pro-rata between periods (unless closing-of-the-books election under §1377(a)(2))
• Can re-elect S status after 5 years (60 months) unless IRS consents to earlier

Inadvertent Termination Relief

If termination was not intended to end S election and company/shareholders acted as if S election remained valid:

• Rev. Proc. 2022-19: Self-correction available for 6 situations without private letter ruling:
  1. Single stock class requirement violations
  2. Disproportionate distributions
  3. Form 2553/Form 8869 errors/omissions
  4. Missing S-election/QSub acceptance letter
  5. Filing inconsistent returns (1120-S vs 1120)
  6. Correcting non-identical governing provisions

Shareholder Interest Termination (§1377)

If shareholder terminates interest mid-year (sale, gift, death), S corp can elect (with consent of all affected shareholders) to split tax year into two short years. File statement on Form 1120-S; write "SECTION 1377(a)(2)ELECTION MADE" on affected K-1s.

Key Differences: C Corp vs S Corp