S Corporations

How a corporation becomes, operates as and stops being an S corporation: the Form 2553 election and consents, separately stated items, shareholder stock and debt basis, distributions through the accumulated adjustments account, the built-in gains tax, shareholder-employee rules and termination. Basis ordering and distribution ordering are the computations the SEE uses most.

Business Entities and Considerations4 min read7 sections

Must-know for the exam

Every shareholder at the time of the S election must consent on Form 2553; a revocation needs holders of more than half the shares (IRC 1362(a)(2), (d)(1)).
Stock basis order each year: income (including tax-exempt), then distributions, then nondeductible expenses, then losses (IRC 1367(a), 1368(d); Treas. Reg. 1.1367-1(f)).
Debt basis comes only from loans made directly by the shareholder; guaranteeing a bank loan gives none until the shareholder pays (IRC 1366(d)(1)(B); Treas. Reg. 1.1366-2).
With no accumulated E&P, distributions are tax-free up to stock basis and capital gain above it (IRC 1368(b)).
With accumulated E&P, distributions come from AAA first, then are dividends to the extent of E&P, then reduce basis (IRC 1368(c)).
Built-in gains tax: 21% on net recognized built-in gain within 5 years after conversion from C status (IRC 1374; Form 1120-S instructions (2025)).
S status ends if passive investment income exceeds 25% of gross receipts for 3 straight years while C-year E&P exists (IRC 1362(d)(3)).
Health premiums for a more-than-2% shareholder-employee are box 1 wages but not Social Security or Medicare wages (IRC 1372; Notice 2008-1).
After a termination, re-electing S status generally waits 5 years without IRS consent; inadvertent terminations can get relief (IRC 1362(f), (g)).
A late 2025 Form 1120-S costs $255 per shareholder per month, up to 12 months (IRC 6699; Rev. Proc. 2024-40 sec. 3.57).

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Traps that cost marks

Confusing the unanimous consent for the election with the majority needed to revoke.
Requiring unanimous consent to revoke.
Applying the passive income rule to an S corporation with no C corporation E&P.
Using the old 10-year recognition period.
Taking losses before distributions.
Applying partnership liability-sharing rules to S corporations.
Treating the premiums as a tax-free fringe benefit for a 2% shareholder.
Netting section 179 into ordinary income.

Why it matters on the exam

S corporations are pass-through entities that are still corporations under state law, so the SEE tests both sides: corporate rules for formation and eligibility, and flow-through rules for income, basis and distributions. Expect a basis computation, a distribution-ordering question and recall on elections and termination.

Pass-through income is not self-employment income, so shareholder-employees must receive reasonable compensation as wages (Rev. Rul. 59-221).

Election, eligibility and termination

•Eligibility: domestic corporation, up to 100 shareholders, one class of stock, only eligible shareholders (IRC 1361(b)).
•Eligible trusts: grantor trusts, QSSTs, ESBTs and testamentary trusts for a limited period. IRAs and foreign trusts are not eligible.
•QSub: a 100%-owned domestic subsidiary may be elected on Form 8869 and disregarded into the parent; an 80% subsidiary cannot.
•Timing: Form 2553 within 2 months and 15 days of the year the election is to start; late relief under Rev. Proc. 2013-30.
•Revocation by holders of more than half the shares can be effective at the start of the year if made by the 15th day of the 3rd month.
•Inadvertent termination (for example, shares passing to an ineligible holder) can be cured under IRC 1362(f) with corrective action.

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Business Entities and Considerations