S-Corporation Election
A federal tax election under Subchapter S of the Internal Revenue Code that allows a qualifying entity to be taxed as a pass-through rather than as a C-corporation. Made on IRS Form 2553. Subject to strict eligibility rules: 100-shareholder cap, single class of stock, shareholders limited to individuals who are U.S. citizens or residents, estates, and certain trusts and exempt organizations.
An S-corporation election is the federal tax election that allows a qualifying corporation or LLC to be taxed under Subchapter S of the Internal Revenue Code rather than as a C-corporation. The S-corp election produces pass-through tax treatment, corporate income, losses, deductions, and credits are allocated to shareholders pro rata on Schedule K-1, while preserving the entity's corporate structure for state-law purposes. The election is made by filing IRS Form 2553 (Election by a Small Business Corporation).
Eligibility requirements
To qualify as an S-corporation, the entity must (1) be a domestic corporation or eligible domestic LLC; (2) have only allowable shareholders, U.S. individuals, certain trusts and estates, and certain tax-exempt organizations (no partnerships, no corporations, no non-resident aliens); (3) have no more than 100 shareholders (with family members counted as one); (4) have only one class of stock (differences in voting rights are permissible; differences in distribution rights are not); and (5) not be an ineligible corporation (certain banks, insurance companies, and DISCs or former DISCs). If the corporation ceases to meet any requirement, the election terminates effective on and after the date of cessation (§ 1362(d)(2)), subject to relief for inadvertent terminations under § 1362(f).
Filing the election
Form 2553 must be filed with the IRS no later than 2 months and 15 days after the beginning of the tax year the election is to take effect (March 15 for a calendar-year corporation electing for the current year), or at any time during the preceding tax year. All shareholders must consent in writing. For an election made during the year it is to take effect, anyone who held stock earlier that year must also consent, and the corporation must have been eligible on every earlier day of the year, or the election is pushed to the next year (§ 1362(b)(2)). Late elections may qualify for relief under Rev. Proc. 2013-30 if the entity intended to be an S-corporation as of the effective date, failed to qualify solely because Form 2553 was late, requests relief within 3 years and 75 days of the intended effective date (a narrower path exists after that), had reasonable cause and acted diligently once the error was found, and its shareholders state that they reported their income consistently with S-corporation status.
Tax consequences
Income is allocated pro rata to shareholders based on stock ownership, regardless of distributions. Shareholders pay tax at their individual rates on their distributive shares, even if no cash is distributed. Distributions of previously-taxed income are generally tax-free up to the shareholder's basis. The S-corp does not pay federal income tax (with limited exceptions for built-in gains under § 1374 and excess net passive income under § 1375 in C-corp-converted entities).
Reasonable compensation requirement
Shareholder-employees must receive reasonable compensation for services rendered to the corporation. Payments for services that are characterized as distributions may be reclassified as wages, triggering back FICA, FUTA, penalties, and interest. See Reasonable Compensation Doctrine.
When the S-corp election tends to fit
S-corp election is most attractive for: (1) closely-held businesses with U.S. individual owners; (2) businesses generating positive cash flow that owners want to extract; (3) businesses where the FICA savings on the wage-vs-distribution split exceeds the administrative cost; (4) businesses without VC or institutional investor plans. The election is generally a poor fit for businesses planning to seek venture capital, businesses with nonresident alien, partnership or corporate shareholders (who are ineligible), businesses that need more than one class of stock, or founders seeking the Section 1202 gain exclusion, which is available only for C-corporation stock.
For Texas LLCs, one path is to file Form 8832 to elect corporate tax treatment and then Form 2553. The simpler path is a timely Form 2553 alone, which is treated as both elections under Treas. Reg. § 301.7701-3(c)(1)(v)(C). The decision usually turns on (1) whether a reasonable salary is feasible, (2) ownership composition, (3) state-tax implications and (4) exit horizon.