An S corporation offers the tax advantages of a partnership combined with the liability protection of a corporation. However, strict IRS requirements mean that maintaining S corporation status requires careful attention and ongoing compliance.
Benefits of S Corporation Status
Like a C corporation, an S corporation shields shareholders from personal liability. Unlike a C corporation, it is a pass‑through entity, meaning profits and losses flow directly to shareholders’ personal tax returns. This structure helps avoid double taxation, where income is taxed at both the corporate and shareholder levels.
Eligibility Requirements
To qualify as an S corporation, shareholders must file IRS Form 2553. In addition, the corporation must:
- Be a U.S. domestic corporation
- Have no more than 100 shareholders (with certain family members counted as one)
- Have only allowable shareholders (individuals, estates, QSSTs, ESBTs)
- Issue only one class of stock (voting rights may differ, but distribution rights must be equal)
- Not be an ineligible corporation, such as an insurance company or certain financial institutions
Allowable Shareholders
Eligible shareholders include individuals, estates, and certain trusts. Partnerships, corporations, and nonresident aliens cannot hold S corporation shares.
Protecting S Corporation Status
To avoid inadvertent termination:
- Monitor shareholder eligibility and trust terms regularly
- Ensure QSSTs and ESBTs file timely elections
- Include buy‑sell agreement provisions to prevent transfers to ineligible shareholders
- Track the two‑year eligibility period for grantor or testamentary trusts and convert or transfer shares before expiration
- Avoid disproportionate distributions that could create a second class of stock
Stay Compliant
Losing S corporation status can result in significant tax consequences. While the IRS may allow retroactive reinstatement, the process is costly and time‑consuming. Staying vigilant with compliance is the best way to preserve the benefits of S corporation status.