S Corporation Tax Rules — Election, Pass-Through Income, and Shareholder Limits

An S corporation is a regular corporation that has made a special tax election under Subchapter S of the Internal Revenue Code — letting it skip corporate income tax entirely and instead pass all profits and losses through to its shareholders, who report them on individual returns. The "S" stands for Subchapter S, codified at 26 U.S.C. §§ 1361–1379. For small business owners, the S corporation's main attraction over an LLC taxed as a partnership is a potential payroll tax savings strategy: shareholders who work in the business pay themselves a "reasonable salary" subject to FICA, but any remaining profit distribution escapes self-employment tax. As of 2026, there are approximately 5 million S corporations in the United States, making it one of the most common business structures for small and mid-size companies.

Current Law (2026)

Parameter	Value
Core statute	26 U.S.C. §§ 1361–1379 (Subchapter S)
Entity-level tax	Generally none (pass-through)
Maximum shareholders	100 (§ 1361)
Eligible shareholders	U.S. citizens and resident aliens, estates, certain trusts — not corporations or partnerships
Stock classes	Only one class of stock permitted (voting differences OK)
Domestic requirement	Must be a domestic corporation
S election form	Form 2553, filed by 15th day of 3rd month of the tax year
Unanimous shareholder consent	Required for S election
Income/loss reporting	Shareholders report pro-rata share on Schedule K-1
Reasonable compensation requirement	Shareholder-employees must receive reasonable W-2 wages
Built-in gains tax (§ 1374)	21% corporate tax on net recognized built-in gains during 5-year recognition period after conversion from C corp
Passive income penalty (§ 1375)	Corporate-rate tax on excess passive income if S corp has C corp E&P and >25% passive receipts

Legal Authority

26 U.S.C. § 1361 — S corporation defined: a "small business corporation" eligible for S status must be domestic, have only one class of stock, have 100 or fewer shareholders, and have only eligible shareholders (individual U.S. citizens/residents, estates, and certain trusts — not corporations, partnerships, or nonresident aliens)
26 U.S.C. § 1362 — Election; revocation; termination: the election requires unanimous consent of all shareholders; it may be made during the prior year or by March 15 of the current year; the election can be revoked voluntarily or terminated involuntarily if eligibility requirements are violated; after termination, there is generally a 5-year waiting period before re-electing
26 U.S.C. § 1363 — Effect of election on corporation: the S corporation itself pays no income tax (except the § 1374 and § 1375 entity-level taxes); the corporation computes its taxable income like an individual and separately states items that flow through to shareholders
26 U.S.C. § 1366 — Pass-through of items to shareholders: each shareholder takes into account their pro-rata share of the corporation's income, loss, deduction, and credit based on the number of shares held each day of the year; a shareholder cannot deduct losses in excess of their stock basis plus any qualified debt they've loaned the corporation
26 U.S.C. § 1367 — Adjustments to basis of stock of shareholders: stock basis increases with income allocations and decreases with distributions and loss allocations; basis cannot go below zero; proper basis tracking is essential for determining how much loss a shareholder can deduct
26 U.S.C. § 1368 — Distributions: S corporation distributions are first tax-free to the extent of the Accumulated Adjustments Account (AAA) and shareholder stock basis; once basis is exhausted, distributions are taxable; if the S corp has prior C corporation E&P, the AAA ordering rules are critical
26 U.S.C. § 1374 — Tax imposed on certain built-in gains: when a C corporation converts to S status, any gain that was "built in" to the assets at the time of conversion is subject to corporate-rate tax (21%) if the assets are sold within the 5-year recognition period; designed to prevent C corps from converting to S just before selling appreciated assets
26 U.S.C. § 1375 — Tax on excess passive investment income: if an S corporation has accumulated C corporation earnings and profits (E&P) and more than 25% of its gross receipts are passive investment income (rents, royalties, interest, dividends), the excess passive income is subject to corporate-rate tax; if this continues for three consecutive years, the S election is automatically terminated
26 U.S.C. § 1377 — Definitions and special rule: each shareholder's pro-rata share is determined by allocating an equal amount to each day and then by shares outstanding that day; if a shareholder disposes of stock during the year, the parties may agree to use an "interim closing of the books" method instead

The S Corporation Election

Making the S election requires filing Form 2553 with the IRS, signed by every current shareholder — unanimous consent is mandatory. If your S corporation has 75 shareholders and one refuses to sign, the election fails. Timing matters: to be effective for the current tax year, the election must be filed by the 15th day of the 3rd month of that year (March 15 for calendar-year corporations). Filing even one day late makes it effective for the next tax year — though the IRS will accept late elections as valid for the current year if there was reasonable cause.

The election can be accidentally terminated. If the S corporation issues a second class of stock with different economic rights, accepts a nonresident alien as a shareholder, exceeds 100 shareholders, or allows a corporation or partnership to become a shareholder, the election terminates automatically as of the date of the disqualifying event. From that point forward, the corporation is treated as a C corporation. Termination can create complex mid-year allocation issues.

The Payroll Tax Savings Strategy — and the IRS Response

The signature tax planning move for S corporations: a shareholder who works in the business takes a "reasonable salary" from the corporation (subject to FICA — 15.3% combined employer/employee on wages up to $184,500 in 2026, plus 2.9% Medicare above that), and then takes additional profit out as a distribution (not subject to FICA). By paying a modest but "reasonable" salary and then distributing the rest of profits, a shareholder can reduce payroll taxes significantly versus operating as a sole proprietor or single-member LLC (where all net profit is subject to self-employment tax).

The IRS attacks this when the salary is unreasonably low. Under § 3121 and related authority, the IRS can reclassify distributions as wages if the shareholder's compensation does not reflect the fair market value of the services they're providing. Courts have consistently upheld IRS reclassifications when shareholders paid themselves minimal salaries and took large distributions (e.g., $30,000 salary for a highly skilled attorney generating $700,000 in income). A reasonable salary for a given role in a given market is determined by looking at what the corporation would need to pay a third party for the same services.

Pass-Through Income and Basis Tracking

Like a partnership, S corporation income flows to shareholders annually based on their pro-rata stock ownership — whether or not any cash is actually distributed. A shareholder who owns 50% of an S corporation that earns $500,000 must report $250,000 of income on their personal return even if they received no cash distribution that year.

Stock basis starts at the amount paid for the shares, increases each year by the shareholder's allocated income, and decreases by distributions and allocated losses. When a shareholder's stock basis hits zero, they may not deduct additional losses unless they have "debt basis" — meaning they personally loaned money to the S corporation. Unlike partnership debt (where a partner's share of entity-level liabilities increases outside basis), S corporation third-party debt does not create basis for shareholders. Only direct loans from the shareholder to the corporation create debt basis.

Built-In Gains — The 5-Year Tax Trap

The most significant tax cost of converting from a C corporation to an S corporation is the § 1374 built-in gains tax. On the day of conversion, the IRS takes a "snapshot" of all the corporation's assets. Any gain that existed at that moment — in real estate, goodwill, equipment, receivables — is "built in" and subject to corporate-rate tax (21%) if the assets are sold within five years of the S election. After the 5-year recognition period, any gain can be taken by shareholders at individual capital gain rates. The IRS audits conversions carefully to ensure built-in gains aren't being recognized outside the period or excluded from the calculation.

How It Affects You

If you're choosing between an S corporation and a sole proprietorship or LLC: The S corporation's core advantage is payroll tax savings on income above a reasonable salary. Here's the math: a sole proprietor with $150,000 of net business income pays Self-Employment (SECA) tax on the full amount — approximately $18,371 (15.3% on the first $184,500). The same owner operating as an S corporation, paying themselves a reasonable $80,000 salary and distributing $70,000 as an S-corp distribution, pays FICA only on the $80,000 salary — approximately $12,240. The payroll tax savings: ~$6,100/year. The breakeven depends on the overhead of S-corp compliance (payroll, Form 1120-S, quarterly deposits) — typically around $2,000–$3,000/year in additional professional fees. Most tax advisors suggest an S election makes sense when your net business income is consistently above $75,000–$100,000. The restrictions matter too: no foreign shareholders, no corporate shareholders, 100-person cap, one class of stock — if you plan to raise venture capital or bring in institutional investors, an LLC taxed as a partnership is almost always more flexible.

If you're an existing S-corporation shareholder tracking basis: Track your stock basis every year — ideally with a spreadsheet updated when the K-1 arrives. Your basis increases with income allocations and capital contributions; it decreases with loss allocations, deductions, and distributions. Losses exceeding your basis are suspended and carry forward until basis is restored (by contributing capital or making loans to the corporation). Distributions exceeding your basis are taxable as capital gain — not tax-free return of capital — which is a common surprise when shareholders haven't tracked basis. The §199A QBI deduction allows an additional 20% deduction on qualified business income allocated to you (subject to W-2 wage limitations at higher income levels), making basis tracking even more important.

If you're converting a C corporation to S status: Don't convert if you're planning to sell assets or the business within five years — the § 1374 built-in gains (BIG) tax taxes appreciated C corporation assets at the 21% corporate rate if sold within 5 years of the S election. The BIG tax eliminates much of the benefit of the conversion for near-term asset sales. If the C corporation has accumulated earnings and profits (C-corp E&P), work with your advisor to distribute or otherwise clear the E&P before or after electing S status to avoid the § 1375 excess passive income tax (35% tax on passive income if the S corp has C-corp E&P and more than 25% of gross receipts are passive — and potential termination of the S election).

If you're selling your S corporation interest: Gain on sale of S-corp stock is generally capital gain — unlike partnership interests, which have "hot asset" ordinary income recharacterization under § 751. However, the buyer often benefits from an asset sale (which gives stepped-up basis in all assets for depreciation and amortization purposes). If a § 338(h)(10) election is available (typically in acquisitions by other corporations), the buyer gets a deemed asset purchase with step-up, but you face ordinary income on the appreciated assets. This is a negotiating point: buyers typically pay a premium ("gross-up") to compensate you for the higher taxes you bear in an asset vs. stock sale structure.

State Variations

Most states automatically conform to the federal S election, but important variations exist:

States that don't recognize S elections: A handful of states (including New York City, New Hampshire, Tennessee, and Texas for franchise tax purposes) impose entity-level taxes on S corporations that mirror their C corporation taxes — eliminating much of the pass-through benefit at the state level
California: The S corporation pays a 1.5% entity-level franchise tax on net income (with an $800 minimum) even though it's an S corporation; shareholders also pay individual income tax on their allocated shares
State PTE elections: Many states now allow S corporations to elect to pay an entity-level state tax (deductible at the federal level), offsetting the SALT deduction cap; the rules and mechanics vary significantly by state
New York City: NYC imposes a general corporate tax on S corporations — effectively treating them as C corporations for city tax purposes

Implementing Regulations

26 CFR 1.1361-1 — S corporation defined (eligibility requirements: 100-shareholder limit, single class of stock, eligible shareholders, eligible domestic corporation status)
26 CFR 1.1361-2 — Definitions relating to S corporation subsidiaries (qualified subchapter S subsidiary (QSub) rules)
26 CFR 1.1361-3 — QSub election (election procedures, effects on parent and subsidiary, deemed liquidation)

Pending Legislation

S corporation rules are periodically targeted in tax reform. Proposals to expand S corporation eligibility (increase the 100-shareholder limit, allow nonresident alien shareholders) have been introduced but not enacted. The more significant legislative risk is changes to the reasonable compensation / self-employment tax treatment, as various reform proposals have sought to extend FICA to a broader portion of S corporation distributions. No major changes enacted as of 2026.

Recent Developments

The Tax Cuts and Jobs Act (2017) created the § 199A qualified business income (QBI) deduction, which generally allows S corporation shareholders to deduct 20% of their allocated business income (subject to W-2 wage limitations and income caps). This made the S corporation even more attractive for businesses that can maximize W-2 wages to unlock the full QBI deduction. The TCJA also reduced the built-in gains recognition period from 10 years to 5 years (a reduction made permanent). IRS audit activity on S corporation reasonable compensation has increased, with the agency deploying data analytics to flag S corporations with very low wage-to-distribution ratios.

OBBBA S corporation provisions (2025): The One Big Beautiful Bill Act (Pub. L. 119-21, July 4, 2025) permanently extended the § 199A QBI deduction at 20% (the House had proposed 23%, but the final law kept the deduction at its original 20% rate), making the S corporation structure remain attractive for business owners who use it to optimize the employment income/distribution ratio.
Reasonable compensation audit wave: IRS's artificial intelligence-assisted examination program has significantly expanded S corporation reasonable compensation audits. IRS compares S corporation owner compensation to industry median wages using Bureau of Labor Statistics data and industry classification systems; when owner wages fall below the 25th percentile for the owner's occupation and industry, IRS flags the return for examination. Tax Court has sustained IRS's authority to reclassify distributions as wages in dozens of cases; the average audit recovery per case is approximately $40,000-$75,000 in additional employment taxes, penalties, and interest. The DOGE-era IRS staffing reductions have modestly reduced the number of new examinations opened, but pending cases continue.
S corporation basis and loss limitations — active issues: S corporation shareholders can only deduct losses up to their basis in S corporation stock and loans. Transactions that reduce basis below zero — particularly guaranteed debt structures where the guarantee doesn't create actual economic exposure — continue to generate IRS audit issues. The Tax Court's Oren v. Commissioner (2024) addressed whether a shareholder's back-to-back loan arrangement (borrowing from a bank and lending to the S corporation) creates debt basis; the court continued to apply the "economic outlay" doctrine requiring actual economic exposure. Taxpayers with S corporation losses disallowed for basis limitations carry those losses forward until basis is restored.
S election termination traps: Several events inadvertently terminate S elections: issuing a second class of stock with different economic rights (violating the single-class rule); having a shareholder become ineligible (e.g., a nonresident alien acquiring stock through inheritance); and exceeding 100 shareholders. Accidental terminations are common in startup and estate administration contexts where stock transfers happen without tax counsel review. IRS grants inadvertent termination relief under § 1362(f) when taxpayers apply promptly and can show the termination was inadvertent — but the process requires filing a consent agreement with IRS and can be administratively burdensome.