S Corporation
An S corporation is a corporation that makes a valid election to be taxed under Subchapter S. For REG, it blends corporate law with pass-through taxation, making it a favorite area for eligibility, basis, and distribution questions.
Core legal and tax profile
- Owners: Shareholders.
- Liability: Shareholders generally have limited liability.
- Federal return: Form 1120-S.
- Tax character: Usually a pass-through entity with items reported to shareholders on Schedule K-1.
Eligibility requirements
To qualify for S corporation status, the entity must satisfy all of the following requirements simultaneously:
| Requirement | Detail |
|---|---|
| Domestic corporation | Must be organized under U.S. federal or state law |
| Eligible shareholders only | Individuals, estates, certain trusts, and certain tax-exempt organizations. No partnerships, C corporations, or nonresident aliens. |
| Maximum 100 shareholders | Members of one family (up to six generations) may elect to be treated as a single shareholder |
| One class of stock | All outstanding shares must confer identical rights to distribution and liquidation proceeds. Differences in voting rights alone are permitted. |
| Not an ineligible corporation | Cannot be a bank using the reserve method, an insurance company, a DISC, or certain other entities |
:::info One Class of Stock
An S corporation may issue both voting and nonvoting common stock — those are still treated as one class because the economic rights are identical. However, if one class of shares has a preferred distribution right, the corporation has two classes and fails the test.
Debt that is reclassified as equity (e.g., shareholder loans with excessive debt-to-equity ratios) can inadvertently create a second class of stock and terminate the election.
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Election process
Filing Form 2553
The S election is made by filing Form 2553 (Election by a Small Business Corporation) with the IRS.
| Timing Rule | Detail |
|---|---|
| For an existing corporation | File by the 15th day of the 3rd month of the tax year (March 15 for calendar-year corporations) |
| For a new corporation | File within 2 months and 15 days of the earliest of: (1) the beginning of the tax year, (2) the date the corporation first has shareholders, or (3) the date the corporation first has assets or begins business |
| Late election | If filed after the deadline, the election is effective for the following tax year (unless the IRS grants relief) |
Shareholder consent
All shareholders who own stock on the day the election is filed must consent. If stock was transferred during the year the election is to be effective, both the transferor and transferee must consent.
Example: Sarah and Marcus each own 50% of Illini Entertainment, a calendar-year C corporation. To elect S status for 2025, they must file Form 2553 by March 15, 2025, and both must sign the consent.
Termination of S election
An S election terminates under three circumstances:
1. Voluntary revocation
Shareholders holding more than 50% of the shares (voting and nonvoting) must consent to revocation.
| Timing of Revocation | Effective Date |
|---|---|
| Filed on or before the 15th day of the 3rd month | Beginning of the current tax year |
| Filed after the 15th day of the 3rd month | Beginning of the following tax year |
| A specific prospective date is designated | The designated date |
2. Failure to meet eligibility requirements
If the corporation ceases to satisfy any eligibility requirement — for example, a nonresident alien acquires stock — the election terminates on the day the disqualifying event occurs. This creates a short S year ending the day before the event and a short C year beginning on the date of the event.
3. Passive investment income (former C corps only)
If an S corporation has accumulated E&P from C corporation years and its passive investment income exceeds 25% of gross receipts for three consecutive tax years, the election terminates at the beginning of the fourth tax year.
This passive income termination rule applies only to S corporations that have accumulated earnings and profits from a prior C corporation period. A corporation that has always been an S corporation (no C corp E&P) is not subject to this rule.
Short tax years and allocation methods
When the S election terminates mid-year, income must be allocated between the short S year and the short C year using one of two methods:
| Method | Description |
|---|---|
| Pro-rata (default) | Annual income is allocated on a daily basis |
| Specific accounting (closing of the books) | Actual income is assigned to each short year based on when it was earned; requires all affected shareholders to consent |
5-year waiting period
After a termination or revocation, the corporation generally cannot re-elect S status for five tax years without IRS consent. The IRS may waive this period if the termination was inadvertent.
Income and loss flow-through
Ordinary business income
The S corporation computes its income much like an individual. Items that do not require separate treatment are combined into ordinary business income (loss) on Form 1120-S and flow through to shareholders on Schedule K-1.
Separately stated items
Certain items must be separately stated because they may have different tax consequences at the shareholder level:
| Category | Examples |
|---|---|
| Capital gains and losses | Short-term and long-term |
| Section 1231 gains and losses | Gains/losses on business property held > 1 year |
| Charitable contributions | Pass through subject to shareholder-level limits |
| Interest income | Portfolio and tax-exempt |
| Dividend income | Qualified and nonqualified |
| Rental income and losses | Subject to passive activity rules |
| Section 179 deduction | Subject to shareholder-level limits |
| Foreign taxes paid | Eligible for foreign tax credit at shareholder level |
| Investment interest expense | Subject to the investment interest limitation |
Each shareholder reports their pro-rata share based on the percentage of stock owned and the number of days held during the year.
Example: Gies Co. is an S corporation with two equal shareholders. The corporation earns $300,000 of ordinary business income and $40,000 of long-term capital gain. Each shareholder reports $150,000 of ordinary income and $20,000 of LTCG on their individual return.
Qualified Business Income (QBI) deduction
S corporation shareholders may be eligible for the Section 199A QBI deduction — up to 20% of qualified business income passed through from the S corporation. The deduction is taken at the shareholder level, not on the S corporation return. It is subject to W-2 wage and property limitations for higher-income taxpayers.
Fringe benefits for >2% shareholders
A shareholder who owns more than 2% of an S corporation's stock is treated like a partner for fringe benefit purposes. This means:
- Health insurance premiums paid by the corporation are included in the shareholder's W-2 income (but may be deductible as self-employed health insurance on the shareholder's Form 1040)
- Group-term life insurance, meals and lodging exclusions, and other employee fringe benefits are generally not available tax-free to >2% shareholders
The >2% shareholder rule is a frequently tested distinction. Unlike employees, these shareholder-employees cannot receive tax-free fringe benefits from the corporation.
Shareholder basis computation
A shareholder's stock basis in an S corporation determines the tax treatment of distributions and the ability to deduct losses. Stock basis is adjusted annually:
Stock basis ordering
| Step | Adjustment | Direction |
|---|---|---|
| 1 | Beginning stock basis | Starting point |
| 2 | Additional capital contributions | Increase |
| 3 | All income items (ordinary + separately stated) | Increase |
| 4 | Distributions | Decrease (but not below zero) |
| 5 | Nondeductible expenses (e.g., 50% of meals, penalties) | Decrease |
| 6 | Deductible losses and deductions | Decrease (but not below zero) |
:::info Ordering Matters
Distributions reduce basis before losses. This means a large distribution can reduce basis to zero, preventing the shareholder from deducting any passed-through losses in that year.
::: Example — Stock basis computation:
Jamie owns 100% of Bear Co. (S corporation). At the start of the year, her stock basis is $50,000. During the year:
| Item | Amount |
|---|---|
| Ordinary business income | $80,000 |
| Tax-exempt interest | $5,000 |
| Cash distribution | $30,000 |
| Charitable contributions (separately stated) | $8,000 |
| Nondeductible expenses | $2,000 |
Basis calculation:
| Step | Amount |
|---|---|
| Beginning basis | $50,000 |
| + Ordinary income | +$80,000 |
| + Tax-exempt interest | +$5,000 |
| − Distribution | −$30,000 |
| − Nondeductible expenses | −$2,000 |
| − Charitable contributions | −$8,000 |
| Ending stock basis | $95,000 |
Debt basis
Unlike partnerships, an S corporation shareholder gets debt basis only from direct loans made by the shareholder to the corporation. Entity-level debt (e.g., a bank loan to the corporation) does not increase a shareholder's debt basis — even if the shareholder personally guarantees the loan.
| Source of Debt | Increases Basis? |
|---|---|
| Shareholder loans directly to the S corp | ✅ Yes |
| Bank loan guaranteed by shareholder | ❌ No |
| Third-party loans to the corporation | ❌ No |
| Entity-level mortgage | ❌ No |
:::caution S Corp vs. Partnership Debt Basis
This is one of the most important distinctions on the exam. In a partnership, a partner's share of entity-level liabilities increases outside basis. In an S corporation, only direct shareholder-to-entity loans count. Guarantees do not create debt basis for S corporation shareholders.
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Tax basis limitation on losses
A shareholder can deduct passed-through losses only to the extent of their combined stock basis and debt basis (tax basis limitation).
Losses exceeding this limit are suspended and carried forward indefinitely until the shareholder obtains sufficient basis.
Loss ordering: Losses first reduce stock basis to zero, then reduce debt basis to zero.
Basis restoration: When debt basis has been reduced by losses, subsequent income first restores debt basis before increasing stock basis.
Example: Marcus owns 100% of Illini Security (S corp). His stock basis is $10,000, and he has loaned the corporation $15,000 (debt basis = $15,000). The corporation passes through a $35,000 ordinary loss.
| Step | Amount |
|---|---|
| Total basis available | $10,000 + $15,000 = $25,000 |
| Loss passed through | $35,000 |
| Deductible loss | $25,000 (limited to basis) |
| Suspended loss | $10,000 (carried forward) |
| Ending stock basis | $0 |
| Ending debt basis | $0 |
Accumulated Adjustments Account (AAA)
The AAA tracks the cumulative net income that has already been taxed to shareholders but not yet distributed. It is most important when the S corporation has accumulated E&P from prior C corporation years.
Distribution ordering with accumulated E&P
When an S corporation has both AAA and accumulated C corporation E&P, distributions are applied in this order:
| Priority | Source | Tax Treatment |
|---|---|---|
| 1st | AAA | Tax-free return (reduces stock basis) |
| 2nd | Accumulated E&P (from C corp years) | Taxed as dividend income |
| 3rd | Remaining stock basis | Tax-free return of capital |
| 4th | Excess | Capital gain |
:::tip AAA Can Go Negative
Unlike stock basis, the AAA can be reduced below zero by losses and deductions. However, distributions cannot reduce AAA below zero — only losses can.
::: Example: Bear Co. converted from a C corporation to an S corporation several years ago. It has AAA of $60,000, accumulated E&P of $40,000, and distributes $120,000 to its sole shareholder (stock basis of $100,000).
| Layer | Amount | Treatment |
|---|---|---|
| AAA | $60,000 | Tax-free (reduces stock basis to $40,000) |
| Accumulated E&P | $40,000 | Dividend income |
| Remaining basis | $20,000 | Tax-free return of capital (reduces stock basis to $0) |
| Total distributed | $120,000 |
Compensation issues
Shareholder-employees who perform services must receive reasonable compensation as wages. This is a major exam issue because wages are subject to payroll taxes, while distributions are not.
When businesses choose an S corporation
S corporations are often attractive for closely held businesses that want:
- Liability protection
- Pass-through taxation
- Potential payroll tax planning compared with sole proprietorship or partnership treatment
They are less useful when owners need multiple classes of stock or want institutional investors.
Advantages and disadvantages
| Topic | S Corporation |
|---|---|
| Liability protection | Strong |
| Tax regime | Pass-through taxation |
| Ownership restrictions | Significant |
| Capital raising | More limited than a C corporation |
| Exam focus | Eligibility, basis, distributions, and reasonable compensation |
REG quick hits
- S corporations file Form 1120-S.
- They are usually pass-through entities — no entity-level tax in most cases.
- Eligibility: domestic corporation, ≤ 100 shareholders, eligible shareholders only, one class of stock.
- Election is made on Form 2553 by the 15th day of the 3rd month.
- All shareholders must consent to the election.
- Termination can occur through voluntary revocation, disqualifying events, or excess passive income (3 years with C corp E&P).
- A 5-year waiting period applies before re-election after termination.
- Shareholders may take the QBI deduction (up to 20%) on passed-through income.
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2% shareholders are treated as partners for fringe benefit purposes.
- Stock basis: contributions + income − distributions − nondeductible − losses.
- Debt basis comes only from direct shareholder loans — entity-level debt and guarantees do not count.
- Maximum deductible loss = stock basis + debt basis.
- Suspended losses carry forward indefinitely.
- The AAA controls the tax treatment of distributions when accumulated E&P exists.
- Reasonable compensation is a recurring exam issue.
Bottom line
An S corporation gives small business owners corporate liability protection without regular C corporation taxation, but the election comes with strict eligibility limits. On REG, know the qualification rules, election timing, termination triggers, basis limits (especially the stock-plus-debt-only rule), distribution ordering with the AAA, and wage-versus-distribution issues.