S Corporations: Eligibility and Election
Before the advent of limited liability companies (“LLCs”) in the 1990s, it was not unusual for a limited partnership to have as its sole general partner an “S corporation,” the shareholders of which corporation were the limited partners themselves. This had the effect of not only providing a limited liability shield for all of the owners of a given business venture, it provided “pass-through” treatment for all of the business venture’s profit and loss, as well. This is because, despite its name, an “S corporation” is not a “corporation” at all, at least not in the sense that it is subject to the corporate income tax of section 11 of the Internal Revenue Code. Instead, an S corporation is more like a partnership, at least for income tax purposes, with all of the income, gain, deductions, losses, and credits that the S corporation recognizes “passing through” and being taxed directly to the shareholders themselves.
Any eligible U.S. corporation (and even some non-corporate entities like LLCs) can make the election to become an S corporation. So long as there are not more than 100 shareholders, all of whom must, essentially, be natural persons, and so long as the corporation issues only a “single class of stock,” the election may be made at any time, including from the moment of the corporation’s existence.
Pass-through Tax Treatment
The hallmark of C corporations is that their income is taxed twice: once under section 11 when the corporation recognizes the income, then again when that income (net of the corporate tax) is distributed (i.e., paid) to the corporation’s shareholders, typically in the form of taxable dividends. By electing to be an S corporation, this double-taxation is avoided, with the shareholders themselves recognizing directly all of the S corporation’s taxable income. This makes the S corporation a “tax accounting” entity as opposed to a “taxpaying” entity. That is to say, the S corporation must still account for its own gross income, its deductions, and so on at the corporate level, but then it passes those items through to its shareholders who themselves pay the resulting tax. Indeed, except for a few specific circumstances, an S corporation itself is never subject to any federal income tax.
As with partnerships, the character of the S corporation’s tax items is maintained as they are passed through to the shareholders. This means, for example, that if the S corporation recognizes ordinary business income, then so do the shareholders (in their “distributive shares” of that income). Similarly, if the S corporation recognizes long-term capital gain or interest income or a section 179 deduction, then so do the shareholders (again, in their distributive shares) recognize long-term capital gain, interest income, and a section 179 deduction. Importantly, essentially only individuals (that is, natural persons) can be shareholders of an S corporation, as we will see below, and accordingly an S corporation must account for its income, deductions, etc. “in the same manner as in the case of an individual.” Thus while the S corporation must be a “domestic corporation” in order to be eligible to make the S election in the first place, it is otherwise not a “corporation” at all, at least not for tax purposes.
Unlike partnerships, the pass-through income of an S corporation must be allocated among the shareholders strictly pro rata according to their stock ownership. Thus a shareholder who owns 50% of an S corporation’s stock must personally take into account 50% of each item of S corporation income, deduction, etc. On the one hand this makes an S corporation an inflexible mechanism for allocating income among a business venture’s owners. Partners in a partnership, for example, can allocate their venture’s items of income and deduction amongst themselves in almost any way they see fit. On the other hand, with only one possible allocation scheme Subchapter S has little in the way of the immense complexities that can be found in Subchapter K, and this relative simplicity can make the S corporation an attractive alternative for many taxpayers.
Making the Election
Any “small business corporation” may make the election to become an S corporation. We will look at what a “small business corporation” is below. Before we get to that let’s focus on the election itself.
First of all, all of the shareholders of the S corporation must consent to the election. This is sensible inasmuch as it is the shareholders who will, after the effective date of the election, be responsible for any income tax that may arise with respect to the S corporation’s earning. The election is made by filing with the Internal Revenue Service Form 2553, Election by a Small Business Corporation. In addition to the vital details of the corporation itself (i.e., its federal employer identification number, the date of its incorporation, its address, etc.), all of the shareholders’ information must also be included on the election form, including their Social Security numbers and the percentage of stock in the corporation that they own.
The election can be made for any tax year, though once made it is effective for all subsequent tax years unless it is voluntarily or involuntarily terminated. If the election is for a future tax year the election can be made at any time prior to that effective year. If the election is for the current tax year, however, or if it is to be immediately effective, then the election must be made by the fifteenth day of the S corporation’s third month. Thus, for an S corporation with a calendar tax year (i.e., a tax year ending December 31), the election for the first S corporation tax year must be made by March 15 of that tax year.
The “Small Business Corporation”
As mentioned above, any “small business corporation” can elect to be an S corporation. The word “small” here does not refer to the amount of the corporation’s earnings or the value of its assets. Rather, “small” refers to the limitation on the number of eligible shareholders (i.e., 100). The S corporation itself can really be of any size in terms of its earnings and wealth.
Specifically, a “small business corporation” is (1) an eligible domestic corporation that (2) has a single class of stock and (3) 100 or fewer shareholders who (4) are natural persons (or certain estates or trusts) and who (5) are residents of the United States.
(1) Eligible domestic corporation. A “domestic” corporation is an entity that qualifies as a “corporation” and which was organized in a U.S. jurisdiction. Foreign—i.e., non-U.S.—corporations cannot make an S election, therefore. Certain types of corporations, such as some financial institutions and insurance companies, also do not qualify. Interestingly, however, the term “corporation” can refer to an entity like an LLC that has made an election under Reg. § 301.7701-2 (the “check-the-box” regulation) to be considered a corporation. Once that election is made by an entity like an LLC, it is considered a “corporation” for all federal tax purposes, including for the purpose of making an S election, and thus an LLC can be an “S corporation.”
(2) A single class of stock. Recall that the shareholders of an S corporation must take into account their pro rata shares of their S corporation’s taxable income, etc. This is a rigid allocation rule with no possibility of variation. The single class of stock requirement is consistent with this rule, requiring that all of the shares of stock of an S corporation have identical rights to distributions and the proceeds of liquidation. Note that non-pro rata distributions among the shareholders (e.g., a 50% shareholder receiving more or less than 50% of the cash distributions in any given year) can be considered as creating a second class of stock and thereby automatically terminate the S corporation’s S election.
(3) No more than 100 shareholders. When originally passed into law Subchapter S allowed only 10 shareholders. This was later increased to 35 and then increased again to 100, suggesting that the concept of a “small” corporation has evolved over the decades. The rules for determining what a “shareholder” is for purposes of the 100-shareholder rule are beyond the scope of this article. However, a husband and wife are generally considered one shareholder, while stock held by a partnership as the nominee for its partners will mean that each partner will be considered an individual shareholder in the S corporation.
(4) Only individuals (and their trusts and estates). As mentioned above, an S corporation is a tax accounting entity (rather than a taxpaying entity) that tracks its income, etc. “in the manner of an individual.” Consistently, only individuals—that is, natural persons—can be S corporation shareholders. Corporations and partnerships (including LLCs) cannot be, except as nominees for an individual. Individuals do (unfortunately) die, however, thus the trust or estate of a deceased shareholder can hold S corporation stock during the time it takes to settle the decedent’s estate.
(5) No nonresident aliens. As the income, deductions, etc. of an S corporation pass through to its shareholders to be recognized directly by them on their personal returns it should go without saying that those individuals should be U.S. taxpayers. If some portion of an S corporation’s earnings were allocated to a nonresident, non-U.S. taxpaying shareholder, then that portion of those earnings would escape U.S. taxation. Accordingly, only U.S.-taxpaying individuals may own stock in an S corporation.
 Section 1361(a)(1) of the Internal Revenue Code of 1986, as amended (the “Code” or “IRC”), provides that the term “S corporation” means any “small business corporation” that has properly made the election to be subject to Subchapter S. Subsection (a)(2) in turn provides that any corporation that has not made the election is instead a “C corporation” as any such non-electing corporation is instead subject to Subchapter C.
 In a limited partnership there must always be one “general partner” with unlimited liability. By making a corporation the general partner, however, that “unlimited” liability is, in effect, limited to the corporation itself, with the corporation’s shareholders enjoying limited liability from the corporate general partner’s creditors. If this corporation’s only activity is its management of the limited partnership, then its only creditors would be the creditors of that limited partnership, and if the corporate general partner’s shareholders are the same persons who are the limited partners of the limited partnership, then, in effect, all of the business venture’s owners will have limited liability protection. Today the same limited liability protection for all of a business venture’s owners can be achieved simply by engaging in the business venture via an LLC.
 See IRC § 1363(a).
 IRC § 1366(a)(1).
 An S corporation can become liable for a corporate-level tax on its “recognized built-in gains” (IRC § 1374). This rule prevents a C corporation from making an S election immediately prior to liquidating its assets and thereby avoiding having to pay a corporate tax on the resulting gain. Under section 1374, an S corporation will be liable for a corporate-level tax on any gains it recognizes during the 10-year period following its S election, but only if those gains were accrued but as yet unrealized (that is, built-in) as of the date of the election. A newly formed corporation that immediately makes an S election is still subject to section 1374, but because it will have no assets at the moment of its formation there will be no built-in gain. The very next section of the Code, section 1375, also imposes a corporate-level tax on an S corporation, but only if the S corporation has “accumulated earnings & profits,” or “E&P.” E&P is the account that all C corporations maintain to track the amount of income it has recognized and paid a corporate-level (section 11) tax on. As S corporations are not subject to the section 11 tax an S corporation will never accumulate E&P. However, a corporation might operate as a C corporation for several years, accumulating E&P all the while, and thereafter make an S election. Section 1375 provides that if this newly-elected S corporation fails to distribute that E&P (and thereby trigger a taxable dividend to its shareholders), but instead retains those earnings and invests them in some passive activities, a corporate-level tax is imposed as if the E&P had actually been distributed.
 S corporations can be subject to state income tax, however. In California, for example, an S corporation must pay a 1.5% tax on its net income with an $800 “minimum franchise tax” due annually whether the S corporation has net income or not. Moreover, if an S corporation is an employer it may be subject to certain federal payroll taxes, such as FICA, on the wages it pays to its employees.
 IRC § 1366(b).
 IRC § 1363(b).
 IRC §§ 1366(a), 1377(a).
 See IRC § 704(a) (providing that the distributive shares of the partners of a partnership shall be determined by the partners’ agreement).
 The “substantial economic effect” rules governing section 704(b) (Treas. Reg. § 1.704-1 et seq.), for example, are probably some of the most complex and difficult to implement rules to be found anywhere in the tax law.
 IRC § 1362(a)(2).
 IRC § 1362(b)(1)(A).
 IRC § 1362(b)(1)(B).
 The IRS is surprisingly lenient with this rule, however, and late elections are relatively simple to remedy. Indeed, the election form itself has room to explain a late election and request effectiveness despite the untimeliness of an election’s filing. See Box H, Form 2553.
 IRC § 1361(b)(2).
 See Treas. Reg. § 1.1361-1(l)(1).
 IRC § 1361(c)(1); Treas. Reg. § 1.1361-1(e)(2).
 Treas. Reg. § 1.1361-1(e)(1).