An S-corporation is a pass-through entity - the corporation pays no federal income tax at the entity level. Instead, income, deductions, credits, and losses flow through to shareholders and are reported on their individual returns in proportion to stock ownership. The primary tax advantage over a C-corporation is elimination of double taxation. The primary tax advantage over a sole proprietorship or partnership is the ability to split earnings between W-2 wages (subject to employment tax) and K-1 distributions (not subject to SE tax or FICA) - but only if compensation is "reasonable" for the services rendered.
100 shareholder limit: An S-corp may not have more than 100 shareholders. Members of a family (as defined by IRC §1361) count as one shareholder.
Eligible shareholders only: Shareholders must be US citizens or resident aliens, certain trusts, or estates. Partnerships, corporations, and most LLCs cannot be S-corp shareholders. Nonresident aliens cannot hold S-corp stock.
One class of stock: An S-corp may have only one class of stock. Differences in voting rights are permitted, but economic rights must be identical - no preferred stock, no different dividend or liquidation rights. Governing document provisions that create a second class of stock inadvertently terminate the S election.
Domestic corporation: Must be incorporated in the US.
The primary SE tax savings strategy with an S-corp: shareholder-employees pay themselves a reasonable W-2 salary (subject to FICA at 15.3% up to the Social Security wage base, then 2.9% Medicare above that), and receive additional profit distributions through K-1 (not subject to FICA or SE tax). This split saves self-employment tax on the K-1 portion.
The IRS requires that shareholder-employees receive reasonable compensation for services performed before taking distributions. "Reasonable" means what an arm's-length employer would pay for similar services. The IRS has aggressively audited S-corps paying minimal or zero W-2 wages and taking all profits as distributions. Courts have consistently upheld IRS recharacterizations of distributions as wages in these cases.
Each shareholder tracks their stock basis separately. Basis is increased by income items allocated from the S-corp and by additional capital contributions. Basis is decreased (but not below zero) by distributions, losses, and deductions. Losses can only be deducted to the extent of the shareholder's basis in stock plus their basis in loans made directly to the corporation. Excess losses are suspended and carried forward until the shareholder has sufficient basis to absorb them.
When a C-corporation converts to S-corp status, appreciated assets that existed at the conversion date carry a potential corporate-level tax. Under IRC §1374, if any of those appreciated assets are sold within five years of the S election, the S-corp pays corporate income tax at 21% on the built-in gain recognized. This prevents C-corps from converting to S status solely to avoid double taxation on a pending asset sale. After the five-year recognition period expires, all gain is fully pass-through with no entity-level tax.