An S Corporation election (IRS Form 2553) allows a qualifying corporation or LLC to be taxed as a pass-through entity — income and losses flow to shareholders' personal returns and are not taxed at the corporate level, avoiding double taxation.
Subchapter S of the Internal Revenue Code (IRC §§ 1361-1379) creates a special tax classification for eligible corporations. Instead of the corporation paying corporate income tax and shareholders paying tax again on dividends (the C-corp 'double tax'), an S-corp passes all income, deductions, credits, and losses directly to shareholders in proportion to ownership. Shareholders report this on Schedule K-1 filed with their Form 1040. To elect S-corp status, an eligible corporation or LLC files IRS Form 2553 (Election by a Small Business Corporation) signed by all shareholders. The election must be filed by March 15 for the election to take effect for the current tax year (or the 15th day of the 3rd month of the corporation's tax year). Eligibility requirements: (1) domestic corporation; (2) one class of stock only; (3) no more than 100 shareholders; (4) shareholders must be U.S. citizens or residents, estates, or qualifying trusts — no partnerships or corporations as shareholders; (5) not an ineligible corporation (certain financial institutions, insurance companies, international sales corporations are excluded). For small business owners, the most significant benefit of S-corp status is payroll tax savings. Shareholder-employees must pay themselves a 'reasonable compensation' as W-2 salary (subject to Social Security and Medicare taxes), but additional distributions from the S-corp are not subject to self-employment tax — only income tax. This split can save 15.3% SE tax on the distribution portion. The IRS scrutinizes 'unreasonably low' salaries in S-corps at irs.gov/businesses/small-businesses-self-employed/s-corporations.
Yes. An LLC that meets S-corp eligibility requirements can file Form 2553 to be taxed as an S-corp. Technically, the LLC is first treated as a corporation for tax purposes (either by default or by separately filing Form 8832), then makes the S-corp election. Many tax advisors recommend the LLC-taxed-as-S-corp structure for small businesses because it combines LLC legal flexibility with S-corp tax savings. See IRS guidance at irs.gov/businesses/small-businesses-self-employed/limited-liability-company.
The IRS requires S-corp shareholders who perform services to pay themselves a salary comparable to what they would pay an unrelated employee for the same work. 'Reasonable' is determined by industry, role, geography, and business revenue. The IRS actively audits S-corps where the owner receives minimal salary and high distributions — see irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues. Consult a CPA to set a defensible salary.
Key downsides: (1) payroll compliance burden — must run payroll, file quarterly Forms 941, file W-2s; (2) the one-class-of-stock restriction limits venture capital investment (VCs typically require preferred stock, which disqualifies S-corp status); (3) the 100-shareholder cap limits growth; (4) fringe benefits for shareholder-employees greater than 2% ownership are treated as wages, not pre-tax benefits — health insurance, HSA contributions, life insurance lose their employer-side tax exclusion under IRC §1372.