S-Corporation Election
A federal tax election under Subchapter S of the Internal Revenue Code that allows a qualifying entity to be taxed as a pass-through rather than as a C-corporation. Made on IRS Form 2553. Subject to strict eligibility rules: 100-shareholder cap, single class of stock, only U.S. individuals and certain trusts as shareholders.
An S-corporation election is the federal tax election that allows a qualifying corporation or LLC to be taxed under Subchapter S of the Internal Revenue Code rather than as a C-corporation. The S-corp election produces pass-through tax treatment, corporate income, losses, deductions, and credits are allocated to shareholders pro rata on Schedule K-1, while preserving the entity's corporate structure for state-law purposes. The election is made by filing IRS Form 2553 (Election by a Small Business Corporation).
Eligibility requirements
To qualify as an S-corporation, the entity must (1) be a domestic corporation or eligible domestic LLC; (2) have only allowable shareholders, U.S. individuals, certain trusts and estates, and certain tax-exempt organizations (no partnerships, no corporations, no non-resident aliens); (3) have no more than 100 shareholders (with family members counted as one); (4) have only one class of stock (differences in voting rights are permissible; differences in distribution rights are not); and (5) not be an ineligible corporation (certain banks, insurance companies, and possessions corporations). Failure of any requirement at any time terminates the election retroactively to the failure.
Filing the election
Form 2553 must be filed with the IRS no later than 2 months and 15 days after the beginning of the tax year the election is to take effect (75 days for a calendar-year entity electing for the current year), or at any time during the preceding tax year. All shareholders must consent in writing. Late elections may qualify for relief under Rev. Proc. 2013-30 if the entity intended to be an S-corporation, has filed all required returns consistent with S-corp status, and has reasonable cause for the late filing.
Tax consequences
Income is allocated pro rata to shareholders based on stock ownership, regardless of distributions. Shareholders pay tax at their individual rates on their distributive shares, even if no cash is distributed. Distributions of previously-taxed income are generally tax-free up to the shareholder's basis. The S-corp does not pay federal income tax (with limited exceptions for built-in gains under § 1374 and excess net passive income under § 1375 in C-corp-converted entities).
Reasonable compensation requirement
Shareholder-employees must receive reasonable compensation for services rendered to the corporation. The IRS has identified inadequate reasonable compensation as an ongoing audit priority for S-corporations. Distributions characterized as anything other than wages may be reclassified as wages, triggering back FICA, FUTA, penalties, and interest. See Reasonable Compensation Doctrine.
When S-corp is the right choice
S-corp election is most attractive for: (1) closely-held businesses with U.S. individual owners; (2) businesses generating positive cash flow that owners want to extract; (3) businesses where the FICA savings on the wage-vs-distribution split exceeds the administrative cost; (4) businesses without VC or institutional investor plans. S-corp election is NOT appropriate for businesses planning to seek venture capital, businesses with non-U.S. or institutional shareholders, businesses requiring multiple classes of stock, or businesses qualifying for Section 1202 founder gain exclusion (which requires C-corp status).
For Texas LLCs, the most common path is: form as LLC, file Form 8832 to elect corporate tax treatment, then file Form 2553 to elect S-corp status, or use the simplified path by filing Form 2553 alone, which is treated as both elections. S-corp election should be a deliberate decision after analysis of (1) reasonable compensation feasibility; (2) ownership composition; (3) state-tax implications; (4) exit horizon. Business owners considering S-corp election should run reasonable-compensation analysis before electing, since the post-election reclassification risk is meaningfully larger than the up-front complexity of getting compensation right.