Business Entities and Considerations · Business entities

S corporations

Subchapter S is a set of conditions attached to a corporation that is, in every other respect, an ordinary state-law corporation. Nothing about the entity changes when the election is made; what changes is that the tax stops at the entity and lands on the shareholders. The examination tests the conditions much harder than it tests the consequences, because the conditions are the part that can be lost by accident — a share issued to the wrong holder, a second class of stock created without anyone intending one, an election filed a day late.

The rule

Who may elect. a domestic corporation that is not an ineligible corporation and does not have more than 100 shareholders, does not have a shareholder who is not an individual other than an estate, a qualifying trust or a qualifying exempt organisation, does not have a nonresident alien shareholder, and does not have more than one class of stock (IRC § 1361(b)(1))^TY2026Verified 2026-08-21IRC § 1361(b), read at law.cornell.edu/uscode/text/26/1361

Each of those five conditions has to hold on every day the election is in force, not merely on the day it was made. The 100-shareholder ceiling is the one that sounds most binding and is in practice the loosest, because of the counting rule that follows.

How shareholders are counted. a husband and wife and their estates count as one shareholder, and all members of a family and their estates count as one — a family being a common ancestor, that ancestor's lineal descendants and the spouses and former spouses of either, with the common ancestor no more than 6 generations removed from the youngest generation of shareholders (IRC § 1361(c)(1))^TY2026Verified 2026-08-21IRC § 1361(c)(1), read at law.cornell.edu/uscode/text/26/1361

The aggregation is automatic. There is no election to make and no form to file; a family that meets the six-generation test simply is one shareholder for the purpose of the ceiling. A corporation with two hundred natural persons on its stock ledger can be comfortably inside the limit if they descend from a common ancestor.

Which trusts may hold the stock. the trusts that may hold S corporation stock are a wholly grantor trust of a United States citizen or resident; that same trust after the deemed owner dies, but only for the 2-year period beginning on the day of death; a testamentary trust, but only for the 2-year period beginning on the day the stock is transferred to it; a voting trust; an electing small business trust; and, for bank stock only, certain individual retirement accounts (IRC § 1361(c)(2)(A))^TY2026Verified 2026-08-21IRC § 1361(c)(2)(A), read at law.cornell.edu/uscode/text/26/1361

When the election is made. at any time during the preceding taxable year, or during the taxable year on or before the 15th day of the third month of it — an election made after that date in the year is treated as made for the following taxable year (IRC § 1362(b))^TY2026Verified 2026-08-21IRC § 1362(b), read at law.cornell.edu/uscode/text/26/1362

The effect of the election. An S corporation is not subject to the taxes imposed by chapter 1 (IRC § 1363(a)), and its items pass through to the shareholders, who take them into account whether or not anything is distributed. A shareholder’s share of losses and deductions cannot exceed the sum of the adjusted basis of the stock and the shareholder’s adjusted basis in any indebtedness of the corporation to that shareholder (IRC § 1366(d)(1)); anything disallowed by that limit is treated as incurred by the corporation in the succeeding year with respect to that shareholder, indefinitely (IRC § 1366(d)(2)(A)).

The return. a calendar-year S corporation files Form 1120-S on or before the 15th day of March following the close of the year, and a fiscal-year S corporation on or before the 15th day of the third month following the close of its year (IRC § 6072(b))^TY2026Verified 2026-08-21IRC § 6072(b), read at law.cornell.edu/uscode/text/26/6072

Distributions. a distribution by an S corporation with no accumulated earnings and profits is not included in gross income to the extent it does not exceed the adjusted basis of the stock, and any excess is treated as gain from the sale or exchange of property (IRC § 1368(b))^TY2026Verified 2026-08-21IRC § 1368(b), read at law.cornell.edu/uscode/text/26/1368

Fringe benefits. for the fringe benefit provisions the S corporation is treated as a partnership and any 2-percent shareholder as a partner — a 2-percent shareholder being anyone owning, or considered as owning under IRC § 318, more than 2 percent of the outstanding stock or of the total combined voting power on any day of the year (IRC § 1372)^TY2026Verified 2026-08-21IRC § 1372, read at law.cornell.edu/uscode/text/26/1372

How the election ends. an election ends by revocation consented to by shareholders holding more than one-half of the shares — retroactive to the first day of the year if made on or before the 15th day of the 3d month, otherwise from the first day of the following year; by the corporation ceasing to be a small business corporation, effective on the date of cessation; or where the corporation has accumulated earnings and profits at the close of each of 3 consecutive years and more than 25 percent of gross receipts in each is passive investment income, effective the first day of the fourth year (IRC § 1362(d))^TY2026Verified 2026-08-21IRC § 1362(d), read at law.cornell.edu/uscode/text/26/1362

Relief where it ended by accident. Where the Secretary determines that the circumstances producing an ineffective election or a termination were inadvertent, steps were taken within a reasonable period after discovery to fix them, and the corporation and every shareholder for the period agree to make the adjustments required, the corporation is treated as an S corporation throughout (IRC § 1362(f)).

The closing-of-the-books election. where a shareholder terminates their entire interest during the year and all affected shareholders and the corporation agree, the year is treated as two taxable years the first of which ends on the date of the termination (IRC § 1377(a)(2))^TY2026Verified 2026-08-21IRC § 1377(a)(2), read at law.cornell.edu/uscode/text/26/1377

Electronic filing. an S corporation must file Form 1120-S electronically if it is required to file at least 10 returns of any type during the calendar year — there is no longer any asset threshold, and the former 250-return figure was replaced for returns required to be filed on or after 1 January 2024 (Reg. § 301.6037-2(a))^TY2026Verified 2026-08-2126 CFR § 301.6037-2, read at law.cornell.edu/cfr/text/26/301.6037-2

Current figures

How it works in practice

The election window is the first thing to get right, and the way it is written trips people who read it quickly. There is no penalty for lateness, because there is no such thing as a late election — an election made after the fifteenth day of the third month is simply an election for the following year. A corporation formed in June that files its election in September has made a valid election, effective the following January, not an invalid one. Whether that is what the client wanted is a different question, and it is the question the practitioner has to raise before the second year’s return is prepared on the wrong assumption.

The one-class-of-stock condition is the one that is most often broken without anyone deciding to break it. The condition is about rights to distribution and liquidation proceeds, not about voting: differences in voting power alone are expressly disregarded by IRC § 1361(c)(4). What creates the risk is informal practice — a shareholder who takes distributions the others do not, a loan from a shareholder on terms that make it look like equity, a buy-sell agreement that fixes different prices for different holders. None of these is a share certificate, and all of them can produce a second class.

The fringe benefit rule at IRC § 1372 is the single most commonly missed item in S corporation practice, and its mechanics are worth being precise about. It does not disallow the benefit. The corporation still deducts what it pays. What it does is deny the shareholder the exclusion, by treating the corporation as a partnership and the shareholder as a partner, so the health insurance premium, the group-term life coverage, the meals and lodging furnished for the convenience of the employer all become compensation included in the shareholder’s income. For health insurance in particular the practical result is usually neutral or better, because the premium reported as wages is then deductible above the line, but that outcome depends on the amount actually being reported. Where it is not reported, the shareholder has taken an exclusion the statute does not allow.

Note the reach of the 2-percent test. It picks up anyone owning, or considered as owning under the IRC § 318 attribution rules, more than 2 percent of the stock on any one day of the year. A person who owns no stock at all but whose spouse owns 40 percent is a 2-percent shareholder. A person who held 3 percent for a fortnight and sold it is a 2-percent shareholder for the whole year.

Distributions under IRC § 1368(b) require the shareholder’s basis to be computed before the character of the distribution can be known, and basis is computed at the end of the year after all the year’s items have been taken into account. This produces the practical awkwardness that a shareholder who takes money out in March cannot know until the following spring whether it was a return of capital or a capital gain. Where the corporation has accumulated earnings and profits from a period before the election, IRC § 1368(c) applies instead and the ordering runs through the accumulated adjustments account first — that is a different rule, and it applies only to corporations with a C corporation history.

Scenarios

How this has changed

The eligibility conditions themselves have been stable for years. What has moved is the filing mechanics.

Electronic filing of Form 1120-S used to be a requirement for large corporations only, tested by two figures at once: total assets and a return count in the hundreds. Reg. § 301.6037-2 as it now reads imposes the requirement on any S corporation required to file at least 10 returns of any type during the calendar year, and drops the asset test entirely. The count is aggregate across return types — information returns, employment tax returns and excise returns all go into it — so a small corporation issuing a modest number of Forms W-2 and 1099 is inside the requirement without ever approaching the old thresholds. The same rewrite reached the C corporation rule at Reg. § 301.6011-5. Any material that still describes an asset threshold for the mandate is describing a regime that no longer exists, and study material written before 2024 very often does.

The six-generation limit in the family aggregation rule is worth noting as a piece of history that is easily mis-stated: the rule as enacted in 2004 was framed differently, and the current formulation — the common ancestor no more than six generations removed from the youngest generation of shareholders, measured for that purpose alone — came with later amendment. Sources describing a three-generation test are describing pre-2005 law.

Exam focus

Expect the conditions rather than the consequences. The recurring shapes are: a corporation that has acquired an ineligible shareholder and the date on which the election ends; a count of shareholders where the point is the family rule; an election filed in the second half of the year and the year it takes effect; a distribution that exceeds basis, where the required answer is gain from the sale or exchange of property and not a dividend; and a fringe benefit paid to an owner, where the required answer is that it is wages.

Read the shareholder-count questions for descent before counting names. Read the election-date questions for the year in which the election was filed as well as the date within it — the fifteenth-day-of-the-third-month line only does work for an election filed during the year it is meant to govern, since an election made at any time in the preceding year is timely regardless of the date. And when a question gives you both a distribution and a year’s income, compute basis at the year end before characterising the distribution; the order is the whole of the question.

Check yourself

1. A calendar-year corporation formed on 3 February 2026 files Form 2553 on 20 July 2026. All shareholders consent. For which taxable year is the election effective?

Answer: 2027. The election was made during the taxable year but after the fifteenth day of the third month of it, so under IRC § 1362(b)(3) it is treated as made for the following taxable year. It is not invalid, and there is no relief to seek unless the corporation wants 2026 covered, which would require relief for a late election under separate administrative authority. For 2026 the entity is a C corporation.

2. An S corporation with no accumulated earnings and profits distributes $80,000 to its sole shareholder during the year. The shareholder’s basis at the start of the year is $25,000 and her share of the corporation’s ordinary income for the year is $40,000. What does she report on the distribution?

Answer: $15,000 of gain. Basis is increased by the $40,000 of income to $65,000. The distribution is tax-free to the extent of that basis under IRC § 1368(b)(1), and the $15,000 excess is treated as gain from the sale or exchange of property under IRC § 1368(b)(2). It is not a dividend.

3. A shareholder owns no stock in an S corporation. His wife owns 30 percent. The corporation pays $14,000 of premiums on a health policy covering him. How is the payment treated on his return?

Answer: as compensation, included in income. Under IRC § 1372 the corporation is treated as a partnership and any 2-percent shareholder as a partner, and the 2-percent test picks up stock a person is considered as owning under IRC § 318 — which attributes his wife’s 30 percent to him. He is a 2-percent shareholder, the employee exclusion does not reach him, and the premium is wages.

4. An S corporation that has never been a C corporation earns 80 percent of its gross receipts as interest and dividends for four consecutive years. Does the election terminate?

Answer: no. IRC § 1362(d)(3) terminates an election only where the corporation both has accumulated earnings and profits at the close of each of three consecutive years and has more than 25 percent passive investment income in each of them. A corporation that has always been an S corporation has no accumulated earnings and profits, so the first limb is never satisfied and the passive income is irrelevant.

5. An S corporation is required to file eight Forms W-2, one Form 1120-S and three Forms 1099-NEC for the calendar year. Its total assets are $900,000. Must it file Form 1120-S electronically?

Answer: yes. Reg. § 301.6037-2(a) requires electronic filing where the corporation is required to file at least 10 returns of any type during the calendar year, and the twelve returns here exceed that. The asset figure is a distractor: the former asset threshold was removed, and no reading of the current regulation makes total assets relevant.