805 / What is an S corporation? How is an S corporation taxed?

An S corporation is one that elects to be treated, in general, as a pass-through entity, thus avoiding most tax at the corporate level.¹ To be eligible to make the election, a corporation must meet certain requirements as to the kind and number of shareholders, classes of stock, and sources of income. An S corporation must be a domestic corporation with only a single class of stock and may have up to 100 shareholders (none of whom are nonresident aliens) who are individuals, estates, and certain trusts. An S corporation may not be an ineligible corporation. An ineligible corporation is one of the following: (1) a financial institution that uses the reserve method of accounting for bad debts; (2) an insurance company; (3) a corporation electing (under IRC Section 936) credits for certain tax attributable to income from Puerto Rico and other U.S. possessions; or (4) a current or former domestic international sales corporation (DISC). Qualified plans and certain charitable organizations may be S corporation shareholders.²

Members of a family are treated as one shareholder. “Members of the family” are defined as “the common ancestor, lineal descendants of the common ancestor, and the spouses (or former spouses) of such lineal descendants or common ancestor.” Generally, the common ancestor may not be more than six generations removed from the youngest generation of shareholders who would be considered members of the family.³

Trusts that may be S corporation shareholders include the following: (1) a trust all of which is treated as owned by an individual who is a citizen or resident of the United States under the grantor trust rules (see Q 797); (2) a trust that was described in (1) above immediately prior to the deemed owner’s death and continues in existence after such death may continue to be an
S corporation shareholder for up to two years after the owner’s death; (3) a trust to which stock is transferred pursuant to a will may be an S corporation shareholder for up to two years after the date of the stock transfer; (4) a trust created primarily to exercise the voting power of stock transferred to it; (5) a qualified subchapter S trust (QSST); (6) an electing small business trust (ESBT); and (7) in the case of an S corporation that is a bank, an IRA or Roth IRA.⁴