What Is an S Corp Election? Form 2553, Taxes, and Salary Rules

An S corp election is a federal tax choice that lets an eligible corporation, or an LLC that qualifies, pass its income, losses, deductions, and credits through to its shareholders instead of paying tax at the corporate level. It’s made under Subchapter S of the Internal Revenue Code by filing Form 2553 with the IRS. The election doesn’t create a new kind of business entity. It changes how an existing one is taxed: the corporation itself generally owes no federal income tax, and shareholders report their share of the profits on their personal returns at their individual rates. That structure eliminates the double taxation C corporation owners face when the company pays corporate tax and then shareholders pay again on dividends.

Who Can Elect S Status

The IRS sets specific eligibility requirements, and the corporation has to meet all of them on every day of the tax year.¹

It must be a domestic corporation, organized under U.S. state or territory law.
It can’t have more than 100 shareholders. Members of the same family count as one shareholder, defined broadly to include a common ancestor, all lineal descendants, and their spouses or former spouses, up to six generations.²
Shareholders must be individuals, certain trusts, or estates. Partnerships, other corporations, and nonresident aliens cannot own shares.
The corporation can have only one class of stock. Every outstanding share must carry identical rights to distributions and liquidation proceeds, though shares can differ in voting rights.³
Every person holding stock on the day the election is filed must sign it.⁴

The one-class-of-stock rule is where accidental disqualifications happen. Preferred stock knocks the corporation out, and so do shareholder agreements or loan arrangements that hand some owners a larger economic slice than their shares would give them. It’s worth reviewing any side agreement for that risk before filing.

LLCs Can Elect S Status Too

You don’t have to form a traditional corporation. A limited liability company can file Form 2553 directly with the IRS, and that single filing does double work: it’s a deemed election to be taxed as a corporation and elects S treatment at the same time, so Form 8832 isn’t required.⁵

One catch. If the LLC files Form 2553 but doesn’t actually qualify on the effective date, it doesn’t become a C corporation. It reverts to its default classification, which is a partnership for a multi-member LLC or a disregarded entity for a single-member LLC. Some owners intentionally file Form 8832 alongside Form 2553 to lock in C corporation treatment as a fallback if the S election fails.

Filing Form 2553

The election is made by filing IRS Form 2553, signed by every shareholder. The form asks for the corporation’s name, address, EIN, the desired effective date, and each shareholder’s consent.⁶

When to File

You can file during the preceding tax year, or no later than two months and 15 days into the tax year you want the election to take effect. For a calendar-year corporation, that’s March 15.⁴ Miss the deadline and the election automatically shifts to the following tax year unless late-filing relief applies.

The election also gets bumped to next year if the corporation failed any eligibility requirement on any day before the election date within that tax year, or if any pre-election shareholder didn’t sign. Corporations that added an ineligible shareholder earlier in the year and didn’t spot the issue until filing often run into this.

Late Election Relief

The IRS will accept a late Form 2553 if the corporation can show reasonable cause. The entity must have intended to be an S corporation, must have reported income consistently with S status since the desired effective date, and all shareholders must have filed their personal returns the same way. The request generally has to be made within three years and 75 days of the intended effective date, though corporations that meet certain conditions can apply after that.⁷

How the Income Gets Taxed

The corporation files Form 1120-S each year reporting total income, deductions, and credits, but generally owes no federal income tax on those amounts.⁸ Every item flows through to shareholders in proportion to stock ownership, and each shareholder gets a Schedule K-1 showing their share.

Shareholders report the amounts on Form 1040. Here’s the part that surprises first-year owners: you owe tax on your share of the profits whether or not the corporation actually distributed cash to you.⁹ Income keeps its character from the corporate level too, so capital gains stay capital gains on your personal return.

Basis Caps How Much Loss You Can Deduct

Your ability to deduct S corporation losses is limited by your basis in the company. Basis starts at what you paid for your stock plus any capital contributions. It goes up each year by your share of income and down by your share of losses and any distributions.¹⁰

You also get basis from money you personally lend directly to the corporation. Guaranteeing a bank loan the corporation takes out does not create basis, even if you’re personally liable if the company defaults. Courts have held that a guarantee is only potential loss, not an actual outlay. You get debt basis only when you actually make a payment on the guaranteed loan.

Losses above your combined stock and debt basis are suspended and carried forward indefinitely, deductible in a later year when you restore enough basis through additional income or contributions.⁹

Distributions

For an S corporation with no accumulated earnings and profits from prior C corporation years, a cash or property distribution is tax-free up to the shareholder’s stock basis. Anything above basis is a capital gain.¹¹

S corporations that carry accumulated earnings and profits from their C corporation days face a layered calculation. Distributions first come out of the accumulated adjustments account (post-election S earnings) tax-free up to basis, then out of the old C corporation earnings as a dividend, and anything beyond that as a capital gain.¹¹

The Reasonable Salary Rule

Any shareholder who works for the S corporation has to receive a reasonable salary before taking distributions. That salary carries Social Security tax (6.2% each for employer and employee on wages up to $184,500 in 2026), Medicare tax (1.45% each), and federal income tax withholding.¹² Distributions don’t carry those employment taxes. That gap creates an obvious incentive to keep salaries low and take the rest as distributions.

The IRS watches this closely. If your salary is unreasonably low for the work you do, the IRS can reclassify distributions as wages and hit the corporation with back employment taxes plus penalties and interest.¹³ There’s no bright-line formula. Courts weigh training and experience, time devoted to the business, what comparable businesses pay for similar work, responsibilities, and the company’s dividend history.¹⁴ This is probably the single most common audit issue for S corporations.

The QBI Deduction on Your Personal Return

S corporation shareholders may qualify for a deduction under Section 199A on their personal returns for a percentage of their qualified business income. The Tax Cuts and Jobs Act originally set this at 20% and had it expiring after 2025. The One Big Beautiful Bill Act, signed on July 4, 2025, made the deduction permanent and raised the rate to 23% for tax years beginning in 2026.¹⁵

If your taxable income sits below the applicable threshold, the math is straightforward: you deduct 23% of your share of the S corporation’s qualified business income. Above the threshold the calculation gets more complex and can be reduced or eliminated depending on the type of business and the corporation’s W-2 wages and qualified property. The thresholds adjust for inflation each year.

The 2025 law also added a “qualifying entity” test: at least 75% of the pass-through business’s gross receipts must come from a qualified trade or business. This is new, and worth reviewing with a tax professional if your S corporation has meaningful investment or passive income alongside its operations.

Health Insurance for Shareholders Who Own More Than 2%

Shareholders who own more than 2% of the stock get unusual treatment on health coverage. The corporation can pay for their health, dental, and vision insurance, but the premiums have to be included in the shareholder’s W-2 wages in Box 1. Those premiums are not subject to Social Security or Medicare taxes as long as the plan covers a broad class of employees.¹³

The shareholder then takes an above-the-line self-employed health insurance deduction on their personal return, which effectively zeroes out the income tax hit. It only works if the corporation established the plan and ran the premiums through the W-2. Shareholders who pay personally and don’t route the premiums through payroll lose the deduction.

Extra Taxes If You Converted From a C Corporation

Two federal taxes can catch former C corporations. Both apply only when the corporation carries accumulated earnings and profits from its C years.

Built-In Gains Tax

If the S corporation sells an asset that was appreciated at the time of conversion, the gain attributable to that pre-conversion appreciation is taxed at the corporate level at the highest rate under Section 11(b), currently 21%. The tax applies during a five-year recognition period starting on the first day of the corporation’s first S year.¹⁶ After five years, the corporation can sell those assets without triggering it. The rule exists to stop C corporations from electing S status just to escape corporate-level tax on gains that built up while they were a C corporation.

Excess Passive Investment Income Tax

An S corporation still carrying accumulated C corporation earnings and profits faces a separate 21% tax if more than 25% of its gross receipts come from passive investment income like interest, dividends, rents, and royalties.¹⁷ The tax hits excess net passive income, not the whole amount. And if passive investment income tops 25% of gross receipts for three consecutive years while accumulated C corporation earnings and profits are still on the books, the S election terminates automatically at the start of the fourth year. Distributing the accumulated C corporation earnings and profits removes the trigger.

How the Election Can End

Once the election is in place, the corporation has to keep meeting every eligibility requirement on every day of every tax year. One slip can end it.

Involuntary Termination

The election terminates automatically if the corporation stops qualifying as a small business corporation. Typical causes: transferring shares to a nonresident alien, selling stock to another corporation or partnership, issuing a second class of stock, or crossing 100 shareholders. Termination takes effect on the day of the disqualifying event, and the corporation reverts to C status from that date forward.⁴

The IRS can waive an inadvertent termination if the corporation promptly fixes the problem and the corporation and all affected shareholders agree to be treated as if the election had never lapsed. Many terminations are accidents (a shareholder dies and leaves stock to an ineligible trust, for example) and this relief exists for exactly those situations.

Voluntary Revocation

Shareholders holding more than half of the outstanding shares (voting and nonvoting combined) can revoke the election at any time by filing a statement with the IRS. If it’s filed by the 15th day of the third month of the tax year, it can be retroactive to the first day of that year. Otherwise it takes effect on the date specified, or the first day of the next tax year if no date is given.¹⁸

The Five-Year Wait Before Electing Again

After any termination or revocation, the corporation generally cannot re-elect S status for five tax years without IRS consent, whether the end was voluntary or not.⁴ The IRS can shorten the wait when circumstances warrant, but counting on that isn’t a plan. Ongoing compliance is cheaper than needing that relief.

State Taxes Don’t Always Follow

The S election is a federal classification, and states aren’t required to follow it. Most do recognize S corporation status and let income pass through to shareholders, but the details vary. Some states impose their own entity-level tax on S corporations, and at least one makes that mandatory. Many others have enacted optional pass-through entity taxes that let S corporations pay state income tax at the entity level so shareholders can claim a federal deduction that works around the $10,000 cap on state and local taxes. Federal S status doesn’t guarantee you’ll avoid entity-level income tax on your state return, so check your state’s treatment before assuming otherwise.

1
Internal Revenue Service. S Corporations
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Office of the Law Revision Counsel. 26 U.S. Code 1361 – S Corporation Defined
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eCFR. 26 CFR 1.1361-1 – S Corporation Defined
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Office of the Law Revision Counsel. 26 USC 1362 – Election, Revocation, Termination
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Internal Revenue Service. About Form 2553, Election by a Small Business Corporation
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Internal Revenue Service. Instructions for Form 2553
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Internal Revenue Service. Late Election Relief
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Internal Revenue Service. About Form 1120-S
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Office of the Law Revision Counsel. 26 USC 1366 – Pass-Thru of Items to Shareholders
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Office of the Law Revision Counsel. 26 USC 1367 – Adjustments to Basis of Stock of Shareholders
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Office of the Law Revision Counsel. 26 USC 1368 – Distributions
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Social Security Administration. Contribution and Benefit Base
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Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues
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Internal Revenue Service. Wage Compensation for S Corporation Officers
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Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income
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Office of the Law Revision Counsel. 26 U.S. Code 1374 – Tax Imposed on Certain Built-In Gains
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Office of the Law Revision Counsel. 26 USC 1375 – Tax Imposed When Passive Investment Income Exceeds 25 Percent of Gross Receipts
18
Internal Revenue Service. Revoking a Subchapter S Election