19.1 Eligibility and Election

19.1 Eligibility and Election

REG Area V, Group C, Topic 1 is the S corporation gate. The Blueprint asks you to recall eligible shareholders, recall S corporation eligibility requirements, and identify situations in which S corporation status would be revoked or terminated. Pass-through computations — ordinary versus separately stated items and the accumulated adjustments account — are Section 19.2. Stock and debt basis are Section 19.3. State-law corporate existence is Section 10.1. This section is federal tax eligibility, not articles of incorporation.

An S corporation is a domestic corporation with a valid election under §1362. It remains a corporation for state law and limited-liability purposes. For federal income tax it is generally a pass-through: items of income, loss, deduction, and credit flow through to the shareholders, and there is ordinarily no corporate-level income tax. Double tax is the C corporation model in Section 18.2. A former C corporation can still face the built-in gains tax under §1374 during the recognition period — a Core flag, not a full computation.

Eligibility — every test at once

The corporation must satisfy all of the following. Failing any one prevents a valid election or terminates an election already in effect.

An LLC that first elects to be classified as an association and then files Form 2553 can be an S corporation. Until both elections are valid, it is not. Check-the-box is Section 20.3.

Eligible versus ineligible shareholders

Eligible on the Core catalog:

• U.S. citizens and U.S. resident aliens (individuals only — not their partnerships)
• A decedent's estate while it holds the stock
• A bankruptcy estate of an individual shareholder
• Certain trusts: a grantor trust wholly owned by a U.S. individual, a qualified subchapter S trust (QSST), an electing small business trust (ESBT), and, for a limited period after a transfer by a will, a testamentary trust

Ineligible — the stems REG writes:

• A partnership, including a multi-member LLC taxed as a partnership
• A C corporation or another corporation as a shareholder (a qualified subchapter S subsidiary is not a second shareholder: a QSub is a 100-percent-owned domestic subsidiary for which the parent S corporation makes a QSub election, and it is disregarded)
• A nonresident alien — one NRA shareholder terminates the election
• Most IRAs and foreign trusts

§501(c)(3) charities and §401(a) qualified plans can be S shareholders. Do not use that exception to admit a partnership or an NRA. On a Core stem, "which of the following cannot be a shareholder" still answers partnership, corporation, or NRA unless the facts are the charity/plan exception.

The 100-shareholder limit and family aggregation

§1361(b)(1)(A) caps the corporation at 100 shareholders. Spouses (and their estates) are treated as one shareholder. Members of a family — a common ancestor, the lineal descendants of that ancestor, and their spouses — may be treated as one shareholder. The common ancestor is not more than six generations removed from the youngest generation of shareholders who would be members of the family. That is why a fact pattern with dozens of children and grandchildren is not automatically over the cap.

Family aggregation does not convert an ineligible owner into an eligible one. A partnership is not "one family member." An estate counts as a shareholder (and is eligible); it is not ignored.

One class of stock

§1361(b)(1)(D) permits only one class. §1361(c)(4) says differences in voting rights are ignored. Voting common and nonvoting common are one class if they confer identical rights to distribution and liquidation proceeds.

Preferred stock with a priority dividend or a senior liquidation preference is a second class. Governing provisions that give one block a larger share of distributions than another, disproportionate to outstanding shares, create a second class. Disproportionate actual distributions can also be treated as a second class when they are more than a timing difference that is promptly corrected. Bona fide buy-sell, redemption, and transfer-restriction agreements do not, standing alone, create a second class.

Form 2553 — unanimous consent and the 2½-month window

File Form 2553, Election by a Small Business Corporation. Every person who is a shareholder on the day of the election must consent. In community-property states both spouses consent. After a valid election, later transferees are bound; they do not re-execute 2553 as a condition of S status (they can still terminate it by being ineligible).

Effective-year timing under §1362(b):

• Filed on or before the 15th day of the third month of the tax year → may be effective as of the beginning of that year. For a calendar-year corporation that date is March 15.
• Filed at any time during the preceding tax year → effective for the following year.
• Filed after the 15th-day-of-third-month window → generally effective the next year, unless late-election relief applies.

A newly formed corporation uses the same clock: no later than two months and 15 days after the beginning of its first tax year. Missing the window is not cured by putting "S corporation" on the letterhead. Late-election relief (reasonable cause, returns filed consistent with S status) is conceptual; it is not a third statutory due date.

Termination, revocation, and inadvertent-termination relief

S status terminates on the day of a terminating event.

A revocation filed by the 15th day of the third month can be effective at the beginning of that year; a later revocation is generally effective the following year or on a specified prospective date. A mid-year terminating event splits the year into an S short year and a C short year. After termination, a new S election is generally barred for five years without IRS consent.

Inadvertent termination relief under §1362(f) is a Core concept, not a form you complete in the exam software. If the corporation and shareholders intended to remain an S corporation, the event was inadvertent, and they promptly restore eligibility — for example, the partnership reconveys the stock to an eligible individual — the IRS may treat the election as never having terminated, subject to adjustments. Relief is not automatic, and it is not a substitute for a timely original 2553.

Built-in gains tax — flag only

If the corporation was a C corporation before the S election (or acquired C assets in a transferred-basis deal), §1374 can impose a corporate-level tax on net recognized built-in gain during the recognition period, currently five years from the first day of S status. REG Core asks you to recognize that a former C corporation still has entity-level exposure on built-in-gain assets. It does not ask you to compute net unrealized built-in gain, apply the taxable-income limitation, or tax a particular asset sale. §1375 excess net passive income tax is the companion flag when accumulated earnings and profits remain and passive receipts are too high. Do not build either model here.

Worked: 100 shareholders, one sells to a partnership

Facts. Maple, Inc. is a calendar-year domestic corporation with a valid S election. After family aggregation it has exactly 100 shareholders, all U.S. individuals. It has one class of voting common. On July 1, one shareholder sells all of that shareholder's stock to a general partnership. Form 2553 was timely years ago.

Analysis. The partnership is an ineligible shareholder. A complete substitution leaves Maple with 100 owners, so the 100-shareholder cap is not the problem. Eligibility fails the moment the partnership holds the stock. S status terminates on July 1. January 1 through June 30 is an S short year; July 1 through December 31 is a C short year. Family aggregation does not rescue a partnership. One class of voting common is still one class. §1362(f) relief is available only if the parties restore an eligible owner and the IRS grants inadvertent-termination relief; the sale itself is a terminating event.

If the shareholder had sold a slice of the stock to the partnership and kept the rest, Maple would have 101 owners and an ineligible shareholder — two independent terminating facts.

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