S Corporations
The S corporation is not a different kind of entity — it is a federal tax election made by an eligible corporation (or sometimes an LLC). Understanding what the S election does, what restrictions it imposes, and when it is appropriate is essential for any business law practice serving small business clients.
An S corporation is a tax classification, not a state law entity form. From a state law perspective, an S corp is identical to a C corp — same formation documents, same governance structure, same fiduciary duties. The S/C distinction is entirely a federal income tax concept. When a client says "I have an S corp," always clarify: is it a corporation under state law, or an LLC that has made an S election? The answer affects your drafting approach significantly.
What the S Election Does
A C corporation is subject to entity-level income tax. An S corporation is not — it is a pass-through entity for federal income tax purposes. This means the corporation's profits and losses "pass through" to the stockholders' personal tax returns, whether or not the corporation actually distributes cash to them.
The practical effect: an S corp eliminates the double taxation that makes C corps unattractive for most small business clients. The business's income is taxed once, at the stockholder level, rather than twice.
The S election is made by filing IRS Form 2553 — "Election by a Small Business Corporation." The election must be timely filed (no more than 2 months and 15 days after the beginning of the first tax year the election is to take effect) and all existing stockholders must consent to the election in writing.
Eligibility Requirements — And Why They Are a Drafting Issue
This is the section of the S corp discussion that transactional lawyers care about most. The eligibility requirements for S corp status are strict, and violating any of them automatically terminates the S election — converting the entity back to a C corp, often with adverse tax consequences.
| Requirement | The Rule | The Drafting Implication |
|---|---|---|
| One class of stock | An S corp may have only one class of stock. All outstanding shares must have identical rights to distribution and liquidation proceeds. Differences in voting rights are permitted. IRC § 1361(b)(1)(D) | The stockholders' agreement and any equity incentive arrangements must be carefully reviewed. Certain debt instruments, options, warrants, and other arrangements can be treated as a "second class of stock" under the IRS regulations, inadvertently terminating S status. |
| 100-stockholder limit | An S corp cannot have more than 100 stockholders. Certain family members may be counted as one stockholder. IRC § 1361(b)(1)(A) | Stock transfer restrictions in the bylaws or stockholders' agreement must prevent transfers that would exceed the limit. Any option grants, convertible notes, or equity compensation arrangements must account for potential share issuances. |
| Eligible stockholders only | With limited exceptions, only US citizens or resident individuals, certain trusts, and certain exempt organizations may be S corp stockholders. IRC § 1361(b)(1)(B) | No corporations, partnerships, nonresident aliens, or most trusts may own S corp stock. Any transfer of stock to an ineligible holder — including through divorce, estate distribution, or a trust modification — terminates S status. Stock transfer restrictions must address this. |
| Domestic corporation | The entity must be a domestic (US-formed) corporation or an eligible entity that has elected corporation status. IRC § 1361(b)(1) | Foreign corporations are ineligible regardless of other factors. Foreign investors cannot receive S corp stock without terminating S status. |
If any eligibility requirement is violated — even unintentionally — the S election is automatically terminated as of the date of the disqualifying event. The corporation becomes a C corp on that date. This can have significant adverse tax consequences, particularly if the entity had previously converted from a C corp to an S corp (built-in gains tax) or has significant retained earnings. Document review for S corp clients must always include a check for potential eligibility issues.
Pass-Through Taxation and K-1s
S corp income and losses flow through to stockholders in proportion to their stock ownership — pro-rata based on shares held, with no ability to specially allocate income or losses to specific stockholders.
K-1 Reporting
Each year, the S corp files Form 1120-S (the S corp tax return) and issues Schedule K-1s to each stockholder. The K-1 reports the stockholder's share of the corporation's income, losses, deductions, and credits. The stockholder includes these items on their personal tax return and pays tax at their individual income tax rates — whether or not the corporation actually distributed cash to them.
This is the "phantom income" problem: a stockholder who receives a K-1 showing $100,000 of income but no distribution must pay tax on that $100,000 out of their own pocket. Well-drafted stockholders' agreements (or S corp operating agreements for LLC/S corps) typically include tax distribution provisions to address this.
Basis Tracking
An S corp stockholder's basis in their stock is the foundation for taking loss deductions and determining gain or loss on sale. S corp stockholders can deduct their share of the corporation's losses only to the extent of their stock and debt basis — and unlike partners in a partnership, S corp stockholders do not get basis credit for their share of the corporation's liabilities. This is a significant disadvantage relative to LLCs when large losses are expected.
The Reasonable Compensation Requirement
The most significant ongoing compliance issue for S corporation owner-operators is the IRS's reasonable compensation requirement — and it is the #1 audit trigger for S corps.
Why It Exists
Here is the employment tax arbitrage that makes S corps attractive for owner-operators: only compensation paid to stockholder-employees is subject to FICA (Social Security and Medicare) payroll taxes. Distributions of S corp profits are not subject to payroll taxes. An S corp owner who receives $200,000 of corporate income as a distribution instead of a salary saves roughly $15,300 in self-employment / payroll taxes (at the 15.3% self-employment tax rate on earned income).
The IRS is well aware of this strategy. Its response: S corporation owner-employees must pay themselves a "reasonable salary" for the work they actually perform before taking distributions. If the IRS determines a stockholder-employee is underpaying themselves to avoid payroll taxes, it can reclassify a portion of distributions as wages — imposing back payroll taxes, penalties, and interest.
What "Reasonable" Means
The IRS has not defined a bright-line rule. The factors typically considered include what a hypothetical employer would pay for the same work, the qualifications and experience of the employee, the corporation's financial condition, and what similarly situated companies pay for comparable roles. The key principle: the salary should reflect the fair market value of the services the owner-employee actually provides.
Employment Tax Savings: The Core Benefit
When the reasonable compensation rule is properly navigated, the S corp structure can generate meaningful ongoing tax savings for owner-operators. Here is a simplified illustration:
Scenario: A solo consultant earns $300,000 of net business income.
As a sole proprietor or LLC (taxed as partnership): All $300,000 is subject to self-employment tax (15.3% on the first ~$170k, 2.9% on the remainder), in addition to income tax. Approximate SE tax: ~$25,000.
As an S corp (salary + distribution): Owner pays themselves a reasonable salary of $150,000 (subject to payroll taxes) and takes the remaining $150,000 as an S corp distribution (not subject to payroll taxes). Payroll taxes apply only to the $150,000 salary — approximate payroll tax: ~$11,475. Savings relative to sole prop/LLC: ~$13,500 per year.
Note: These are simplified estimates. Actual savings depend on income level, deductible business expenses, QBI deduction, and other factors. Always involve a CPA or tax attorney for specific advice.
The LLC Taxed as an S Corp
One of the most common structures CLF encounters for Oklahoma operating businesses is not a state-law corporation at all — it is an LLC that has made two IRS elections to achieve S corporation tax treatment.
How It Works
- Form an LLC under Oklahoma law (articles of organization filed with the Secretary of State).
- Make a check-the-box election on IRS Form 8832 to treat the LLC as a corporation for federal income tax purposes. (Without this election, a multi-member LLC defaults to partnership treatment.)
- Make the S corporation election on IRS Form 2553 to elect pass-through tax treatment as an S corp rather than C corp treatment.
The result: an entity that is an LLC under Oklahoma law (with all the LLC's flexibility in governance and operating agreements) but is treated as an S corporation for federal tax purposes (with the S corp's payroll tax savings on distributions).
Why This Structure Is Popular
The LLC/S corp combination is popular because it gives the owner the best of both worlds: the governance flexibility and contractual freedom of the LLC operating agreement, combined with the payroll tax savings available through S corp status. For a single-owner or small-group Oklahoma operating business that doesn't need to raise institutional capital, this is often the optimal structure.
When an LLC has elected S corp status, all of the S corp eligibility restrictions apply — one class of equity, no more than 100 members, eligible members only. The operating agreement must be drafted accordingly. An LLC/S corp that later admits a corporate member, a nonresident alien, or a 101st member will lose its S election automatically. Document review for LLC/S corp clients must always check the membership roster against S corp eligibility rules.
The Built-In Gains (BIG) Tax Trap
If a C corporation converts to S corp status after formation (rather than making the S election at inception), it becomes subject to the built-in gains (BIG) tax under IRC § 1374. This is an important trap for clients considering converting from C to S:
- Any "built-in gains" — appreciation in the value of the corporation's assets that occurred during the C corp years — are subject to corporate-rate income tax if those assets are sold or otherwise recognized within 5 years after the S election takes effect.
- The recognition period is 5 years. If the asset is sold after 5 years, the BIG tax does not apply.
- The BIG tax applies at the corporate level, at the 21% federal corporate rate, in addition to the stockholder-level tax on any gain passed through.
This is a significant issue for any client who is considering converting an existing C corp to S status and might sell the business or distribute appreciated assets within 5 years of the conversion. Always involve a tax advisor before recommending a C-to-S conversion.
When the S Corp Doesn't Work
For all its advantages, the S corp structure has hard limits. Clients who need any of the following cannot use S corp status:
| Client Need | Why S Corp Fails | Better Alternative |
|---|---|---|
| Multiple equity classes | S corp allows only one class of stock (voting differences OK, but no preferred with economic preferences) | C corp (preferred + common) or LLC with multiple classes of interests |
| Corporate, foreign, or trust investors | Only US individuals and certain trusts may be S corp stockholders | C corp or LLC taxed as partnership |
| More than 100 owners | Hard cap; automatic termination if exceeded | C corp or LLC taxed as partnership |
| Special allocations of income/loss | S corps must allocate strictly pro-rata based on stock ownership; no flexibility | LLC taxed as partnership (fully flexible allocation) |
| Basis from entity-level debt | S corp stockholders get no basis for their share of corporate liabilities; limits loss deductions | LLC taxed as partnership (partners get basis for their share of entity debt) |
| Employee equity incentives (profits interests) | S corps cannot issue profits interests; only stock options available, which are less tax-efficient | LLC taxed as partnership (profits interests available) |
| Institutional VC investment | VC funds and their portfolio management structures typically cannot hold S corp stock | Delaware C corp |
CLF's most common encounter with S corporations is through existing clients who formed an LLC years ago, made an S election for tax savings, and are now growing the business or considering bringing in investors. The attorney's job in that conversation is to identify whether the S election is still appropriate given the client's current and projected situation — and if not, to explain the implications of terminating the election or converting to a different structure. The built-in gains trap, the reasonable compensation issue, and the eligibility restrictions are all live issues in those conversations.
Key Terms — Session 04
The filing of IRS Form 2553 by which an eligible corporation (or LLC taxed as a corporation) elects to be treated as an S corporation — a pass-through entity — for federal income tax purposes. The election must be timely filed with the consent of all stockholders.
The tax form issued annually by an S corporation (or partnership or LLC taxed as partnership) to each owner, reporting their share of the entity's income, losses, deductions, and credits. The owner reports K-1 items on their personal income tax return.
The IRS requirement that S corporation owner-employees pay themselves a salary reflecting the fair market value of their services before taking distributions. The IRS may reclassify distributions as wages — imposing back payroll taxes and penalties — if the salary paid is unreasonably low.
A corporate-level tax under IRC § 1374 imposed on net recognized built-in gains of a corporation that converted from C to S status, if those gains are recognized within 5 years of the S election. The tax is assessed at the 21% corporate rate and applies in addition to the pass-through tax on the gain at the stockholder level.
The S corporation's mandatory rule that income, losses, and other tax items must be allocated strictly in proportion to stock ownership — one dollar per share per day. Unlike partnerships and LLCs, S corps cannot specially allocate items to specific stockholders in disproportionate amounts.