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S Corporation Election

A tax election, not a kind of company - what electing S status does to how a corporation or LLC is taxed, who is eligible to make it, and how it is lost.

Informational only - this is not legal advice. These definitions explain general legal vocabulary in plain English. They are not advice about your situation, reading them creates no attorney-client relationship, and the law differs from state to state and changes over time. For advice you can rely on, speak to a lawyer licensed in your state.

What it means

An S corporation is not a separate type of business entity. It is an ordinary corporation, or an LLC that has chosen to be taxed as a corporation, that has elected under Subchapter S of the Internal Revenue Code to have its income, losses, deductions and credits passed through to its owners and reported on their personal returns, instead of being taxed at the company level and again when distributed. The entity itself is still formed, governed and sued under state law exactly as before; only its federal tax treatment changes, and the state's treatment follows only where the state has chosen to conform.

Eligibility is what makes the election fragile. The code limits how many shareholders an S corporation may have and who they may be - individuals, certain trusts and estates, and not partnerships, most corporations or non-resident aliens - and permits only one class of stock, so that every share carries identical rights to distributions and liquidation proceeds. The election is made on a form signed by every shareholder and, to take effect for a given year, must be filed within a window early in that year. Admitting an ineligible shareholder, issuing a second class of stock, or an LLC operating agreement that allocates distributions unequally can terminate the election involuntarily, sometimes without anyone noticing until an audit.

The election is usually made to reduce self-employment tax: an owner who works in the business is paid a salary, subject to payroll taxes, and takes the remaining profit as a distribution that is not. The Internal Revenue Service requires that salary to be reasonable compensation for the work actually done, and recharacterises distributions as wages when it is not. Whether the election saves anything depends on the owner's facts, the state's treatment of S corporations, and the cost of running payroll.

Where this comes from

Internal Revenue Code §§ 1361 (definition of a small business corporation and the eligibility rules), 1362 (election, revocation and termination), 1363 (effect of the election on the corporation) and 1366 (pass-through of items to shareholders), 26 U.S.C. §§ 1361-1366, with Treasury regulations at 26 C.F.R. § 1.1361-1 and following; the election is made on IRS Form 2553. State conformity is set by each state's tax code, and some states impose their own tax on S corporations.

When people hire a lawyer for this

A business owner considering the election should have both a tax adviser and a lawyer look at it, because the tax saving is an accounting question and the eligibility rules are a drafting question: the operating agreement or shareholders' agreement has to keep every owner and every share inside the code's limits for as long as the election is meant to last. An owner who has just learned the election may have terminated should get advice before filing anything, since relief for an inadvertent termination exists but has to be requested properly.

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Part of the LawyerLand plain-English legal glossary. Definitions are written from primary sources - statutes and court rules - and each entry states the authority it rests on, or says plainly when the doctrine is state law with no national rule.

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