S-Corporation: Definition and How It Works

An S-Corporation (S-Corp) is a domestic corporation that has made a valid election under IRC §1362 to be taxed under Subchapter S of the Internal Revenue Code. Unlike a C-Corporation, which pays corporate income tax on its profits and then distributes after-tax earnings to shareholders (who pay dividend tax again — the "double taxation" problem), an S-Corporation is a pass-through entity: its income, deductions, credits, and losses flow through to shareholders and are reported on their individual returns. The corporation itself pays no federal income tax on its operating income. The S-Corp election is one of the most impactful tax planning decisions a small business owner can make, and it is central to the work of nearly every CPA advising privately-held businesses.

How S-Corporation Status Is Elected

A corporation does not become an S-Corp automatically. It must file Form 2553 (Election by a Small Business Corporation) with the IRS, signed by all shareholders. The election is effective for the tax year in which it is filed (if made by the 15th day of the third month of the year) or for the following tax year if filed later. For newly formed entities, IRS Rev. Proc. 2013-30 provides late election relief in many circumstances.

Once elected, S-Corp status remains in effect until it is voluntarily revoked, the corporation becomes ineligible, or the IRS terminates the election for cause (for example, if the corporation inadvertently takes on an ineligible shareholder).

Eligibility Requirements

Not every corporation can elect S-Corp status. IRC §1361 imposes strict eligibility requirements:

• Domestic corporation only. A foreign corporation or LLC taxed as a foreign entity cannot elect S-Corp status.
• One class of stock. The corporation may have only one class of stock — though differences in voting rights between shares of the same economic class are permitted. Preferred stock arrangements, convertible debt, and split-trigger options can inadvertently create a second class of stock and terminate the S-Corp election.
• Maximum 100 shareholders. Members of the same family (broadly defined under §1361(c)(1)) count as one shareholder.
• Eligible shareholders only. Shareholders must be U.S. citizens or resident aliens, estates, certain trusts (qualified subchapter S trusts, electing small business trusts, and grantor trusts), and exempt organizations. Partnerships, corporations, and non-resident aliens cannot be S-Corp shareholders. This restriction is the most frequent reason a growing business must convert from S-Corp to C-Corp when it seeks institutional investment.

How S-Corporation Income Is Taxed

S-Corp income and loss passes through to shareholders in proportion to their stock ownership percentage, as reported on Schedule K-1 (Form 1120-S). Each shareholder includes their allocable share of income, deductions, credits, and separately stated items on their individual return.

The critical tax advantage: distributions from an S-Corp are not subject to self-employment (SECA) tax, provided the shareholder-employee has received a reasonable salary (discussed below). A sole proprietor pays 15.3% self-employment tax on all net business income. An S-Corp shareholder-employee pays FICA taxes only on W-2 wages — distributions above the salary are exempt. For a business generating $200,000 in net income, the S-Corp structure can reduce SE/FICA tax by $10,000–$15,000 annually compared to sole proprietor or single-member LLC taxation.

The Reasonable Salary Requirement

The IRS requires that S-Corp shareholders who perform services for the corporation pay themselves a reasonable salary before taking distributions. The salary must reflect what the corporation would pay an unrelated third party for the same services, based on industry, experience, geographic market, and time commitment.

This requirement is the primary area of IRS scrutiny for S-Corps. A shareholder-employee who takes minimal or no salary and maximizes distributions — avoiding FICA tax on the full amount — risks IRS reclassification of distributions as wages, resulting in back FICA taxes, penalties, and interest. The IRS has prevailed in numerous Tax Court cases on this issue; the most cited is Watson v. Commissioner, 668 F.3d 1008 (8th Cir. 2012), where a CPA's $24,000 salary on $200,000 of income was reclassified.

For the mechanics of calculating and documenting reasonable salary, see How to Calculate and Document a Reasonable Salary for S-Corp Owners.

Shareholder Basis and Loss Limitation

S-Corp shareholders can only deduct their allocable share of losses to the extent of their adjusted basis in S-Corp stock plus any direct loans they have made to the corporation (IRC §1366(d)). Unlike partnerships, S-Corp shareholders do not get outside basis credit for entity-level debt — only loans made directly by the shareholder to the corporation count. A shareholder whose basis is zero cannot deduct further losses; those losses are suspended and carry forward until basis is restored.

Basis is increased by income allocations and additional contributions; decreased by losses, distributions, and non-deductible expenses. Tracking basis is a recordkeeping obligation that falls on the shareholder (not the corporation), and many S-Corp owners — and their CPAs — fail to maintain adequate basis records. For the detailed mechanics, see S-Corp Shareholder Basis: At-Risk Rules, Loss Limitations, and Recordkeeping.

Comparison to Other Pass-Through Structures

Related Terms

• QBI Deduction — S-Corp income qualifies for the 20% (23% under OBBBA) Section 199A deduction as pass-through income, subject to the W-2 wage limitation
• Self-Employment Tax — the SECA tax that S-Corp distributions avoid, unlike sole proprietor income
• Pass-Through Entity Tax (PTET) — state-level elections that allow S-Corps to pay and deduct state income taxes at the entity level, bypassing the federal SALT cap

How CPAs Use the S-Corporation in Practice

The S-Corp election question comes up in two contexts: new entity formation (should a new business start as an S-Corp or LLC?) and existing LLC conversion (should an existing LLC elect S-Corp taxation?).

The conversion typically makes sense when net business income exceeds approximately $60,000–$80,000 annually — the point at which FICA tax savings outweigh the additional compliance costs (payroll administration, Form 1120-S preparation, reasonable salary documentation). For a comprehensive analysis of the breakeven calculation, state-specific complications, and when the election does not make sense, see S-Corp vs LLC: Which Tax Structure Saves More in 2025?.