Who may own an S corporation: shareholders, visas and trusts

An S corporation does not lose its election by being caught. It loses it on the day a condition stopped being met — a share moves to a trust that is not on the list, a shareholder's permanent residence lapses, a student's exempt years run out — and nothing arrives to announce it. No notice is sent, nothing is filed, and the corporation carries on filing as an S corporation for a stretch in which it was not one. The year is not undone when this is discovered. It is split, and both halves are real.

This page is federal law throughout — who may own the stock under §1361, when a visa holder is a nonresident alien under §7701(b), which trusts qualify, and what §1362 does when the election ends. It does not say what your state does with the same election, what you must pay yourself out of the company, or how the entity was classified before it elected. Those are set out at the foot of the page as questions this guide does not answer.

Who may hold the stock

Eligibility is written as a definition and a list of prohibitions rather than as a test anyone passes. §1361(b)(1) says what a small business corporation is, and each lettered clause below it removes something. So the useful question is never whether an arrangement seems reasonable or was done in good faith — it is whether the person, the entity or the trust holding the shares is one the section allows.

§1361(b)(1) defines a small business corporation as “a domestic corporation which is not an ineligible corporation” and which then satisfies four further conditions. The requirement sits in the definition’s opening words, before any of the lettered prohibitions about shareholders, and the section applies it a second time one level down: §1361(b)(3)(B) requires a qualified subchapter S subsidiary to be “any domestic corporation which is not an ineligible corporation”. What makes a corporation domestic is defined at §7701(a)(4) and is not stated in §1361.26 U.S.C. §1361

§1361(b)(1)(B) bars a small business corporation from having “as a shareholder a person (other than an estate, a trust described in subsection (c)(2), or an organization described in subsection (c)(6)) who is not an individual.” The prohibition runs on everything that is not a natural person, and the parenthesis is a closed list of three exceptions rather than three examples — so anything outside it is excluded without the statute having to name it. Both entity exceptions are narrower than they look. §1361(c)(2) is itself a closed list of trust types, so a trust is eligible because it is on that list and has made whatever election the list requires. And §1361(c)(6) is conjunctive: an organization qualifies only if it is “described in section 401(a) or 501(c)(3)” and “exempt from taxation under section 501(a)”, so an exemption of some other kind does not reach it.26 U.S.C. §1361

A partnership and a corporation are each a person that is not an individual, and neither is an estate, a trust described in §1361(c)(2) or an organization described in §1361(c)(6), so under §1361(b)(1)(B) neither may hold stock in an S corporation. Two things that look like exceptions are not. §1361(b)(3) runs in the opposite direction — it governs what an S corporation may itself own, not who may own it. And §1361(c)(6) admits an organization described in §401(a) or §501(c)(3) only where it is also exempt from taxation under §501(a), which is a second condition and not a description of the first.26 U.S.C. §1361

§1361(b)(1)(C) bars a small business corporation from having “a nonresident alien as a shareholder”. Nine words, with no exception written into the clause — and the clause is about holding the stock directly. One share held directly by a nonresident alien is enough to end the corporation’s status as a small business corporation. Family aggregation does not soften it: §1361(c)(1) treats a family as one shareholder “for purposes of subsection (b)(1)(A)”, the 100-shareholder count, and reaches nothing else, so six family members who are nonresident aliens are one shareholder for that count and six independent failures here. Whether an individual is a nonresident alien is settled by §7701(b) and not by §1361.26 U.S.C. §1361

§1361(c)(1)(A) treats “a husband and wife (and their estates)” and “all members of a family (and their estates)” as one shareholder, and it does so “for purposes of subsection (b)(1)(A)” — the 100-shareholder count, and nothing else. Members of a family are “a common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse” of the ancestor or of any such descendant, so a divorce does not put anyone outside the family for this purpose, and §1361(c)(1)(C) brings a legally adopted child, a child lawfully placed for adoption and an eligible foster child inside it by blood. The generation bound at §1361(c)(1)(B)(ii) disqualifies the ancestor rather than the family: an individual “shall not be considered to be a common ancestor if, on the applicable date, the individual is more than 6 generations removed from the youngest generation of shareholders” who would otherwise be members of the family, and the family is then measured from a nearer ancestor instead. A spouse or former spouse is treated as of the same generation as the person married, so marrying in consumes no generation. The applicable date is fixed once, by §1361(c)(1)(B)(iii), as the latest of the date the §1362(a) election is made, the earliest date an aggregated individual holds stock, and 22 October 2004 — a single date rather than a running test.26 U.S.C. §1361

The prohibition on a nonresident alien is about holding the stock directly. Whether the same person may benefit from a trust that holds it is a different question with a different answer, and it is set out under Trusts below. Neither statement qualifies the other: the clause stands in full force, and the trust route works because the beneficiary is never treated as a shareholder for that clause's purposes.

The remaining conditions are about the shares rather than the people holding them, and they are the ones broken after formation rather than failed at it — by what a corporation does with its stock, what it lends and borrows, and what it comes to own.

§1361(b)(1)(D) bars a small business corporation from having “more than 1 class of stock”. §1361(c)(4) supplies the only carve-out the section contains, and it is narrower than the shorthand: a corporation is not treated as having more than one class of stock “solely because there are differences in voting rights among the shares of common stock.” Voting differences, among common stock, and on their own. The affirmative test — what makes two classes rather than one — is not in §1361 at all, so nothing stated here decides whether any particular difference in economic rights creates a second class. This is the condition most often broken after formation rather than failed at it, because it is broken by what a corporation does with its shares and not by who holds them.26 U.S.C. §1361

§1361(c)(5)(A) provides that, for purposes of §1361(b)(1)(D), “straight debt shall not be treated as a second class of stock.” §1361(c)(5)(B) defines straight debt as a written unconditional promise to pay on demand or on a specified date a sum certain in money, and every limb is a condition: the interest rate and interest payment dates must not be contingent on profits, the borrower’s discretion or similar factors; the debt must not be convertible, directly or indirectly, into stock; and the creditor must be an individual other than a nonresident alien, an estate, a trust described in §1361(c)(2), or a person actively and regularly engaged in the business of lending money. Nonresident-alien status therefore bites a second time, in a different paragraph and on a different act: §1361(b)(1)(C) is about holding stock and this condition is about lending money, and it carries no counterpart to the sentence in §1361(c)(2)(B)(v) that switches the deeming rule off for §1361(b)(1)(C). Failing the safe harbour is not itself fatal — §1361(c)(5)(A) is a shelter and not a prohibition, so debt outside it is not thereby a second class of stock, but is tested on principles the section does not state.26 U.S.C. §1361

§1361(b)(2) defines an ineligible corporation as any corporation which is “(A) a financial institution which uses the reserve method of accounting for bad debts described in section 585, (B) an insurance company subject to tax under subchapter L, or (C) a DISC or former DISC.” Three items, and the list is closed — so a corporation in any other line of business is not excluded by its industry, whatever the trade. Item (A) turns on the accounting method rather than on being a bank: §1361 assumes S corporation banks exist and legislates for them three separate times, at (c)(2)(A)(vi), (f) and (g). The list is load-bearing twice, because §1361(b)(3)(B) also requires a qualified subchapter S subsidiary to be “not an ineligible corporation (as defined in paragraph (2))”.26 U.S.C. §1361

§1361(b)(3) answers what an S corporation may own, which is a different question from who may own it. A qualified subchapter S subsidiary is a domestic corporation that is not an ineligible corporation under §1361(b)(2), all of whose stock is held by the S corporation, and which the S corporation elects to treat as a QSub — the first two being the same two conditions the parent itself had to meet. The effect is disregard rather than consolidation: under §1361(b)(3)(A) the subsidiary “shall not be treated as a separate corporation”, and all of its assets, liabilities, and items of income, deduction, and credit are treated as the S corporation’s. Ceasing to qualify is a transaction rather than a change of status — §1361(b)(3)(C)(i) treats the corporation as “a new corporation acquiring all of its assets (and assuming all of its liabilities) immediately before such cessation from the S corporation in exchange for its stock.” And §1361(b)(3)(D) shuts the door behind it: after a QSub election terminates, neither that corporation nor any successor may elect QSub or S status again “before its 5th taxable year which begins after the 1st taxable year for which such termination was effective, unless the Secretary consents to such election.”26 U.S.C. §1361

An individual retirement account is not an eligible S corporation shareholder, and §1361 supplies every step of it. §1361(b)(1)(B) bars a shareholder that is not an individual unless it is an estate, a trust described in §1361(c)(2), or a §1361(c)(6) organization. The section then characterises an IRA as a trust in its own words — §1361(c)(2)(A)(vi) speaks of “a trust which constitutes an individual retirement account under section 408(a), including one designated as a Roth IRA under section 408A” — so an IRA is eligible only if it is on that closed list. The single entry for one is doubly confined: it reaches only a corporation which “is a bank (as defined in section 581) or a depository institution holding company”, and then “only to the extent of the stock held by such trust in such bank or company as of the date of the enactment of this clause.” An IRA holding stock of anything else is not on the list. This is about an IRA holding the stock; it says nothing about an S corporation sponsoring a retirement plan, which is a separate question under §1361(c)(6).26 U.S.C. §1361

Visas and residency

A caller asks about an F-1, or a J-1, or a green card that has not been used in years. The statute answers none of those questions in those words. §7701(b) decides residency by three routes and no others, and the exempt-individual rule that most often decides the answer works from a closed list of immigration categories — so it is the category a person is present in, and not the letter printed on the visa, that selects the result. This matters to an S corporation because §1361(b)(1)(C) is not an annual snapshot: the day a person becomes or stops being a nonresident alien is the day the election survives or does not.

§7701(b)(1)(A) treats an alien as a resident of the United States for a calendar year “if (and only if)” the individual meets one of three requirements: lawful permanent residence, substantial presence, or the first-year election of §7701(b)(4). There is no fourth route — not intent, not domicile, not a state residency determination, not holding a Social Security number, not paying US tax. This is the first of the three: “Such individual is a lawful permanent resident of the United States at any time during such calendar year.” One day is enough, so a green card surrendered in January makes the holder a resident under this clause for the whole of that calendar year. §7701(b)(6)(B) is the half that surprises people: the status holds while it “has not been revoked (and has not been administratively or judicially determined to have been abandoned)”, so abandonment is not self-executing, and a card left unused for years still confers the status until a revocation or such a determination has occurred.26 U.S.C. §7701(b)

§7701(b)(3)(A) sets two conditions and both must hold. The individual must have been “present in the United States on at least 31 days during the calendar year” — a current-year floor standing on its own, so without it there is no substantial presence whatever the three-year history. And the days of presence in the current year and the two preceding calendar years, each multiplied by the applicable multiplier in the statute’s table — the current year in full, the first preceding year at one third, the second preceding year at one sixth — must “equal or exceed 183 days”. That figure is a weighted three-year total rather than a count of days actually spent here, and reaching it makes an individual a resident. One paragraph away, §7701(b)(3)(B) contains a second 183 that is an unweighted count of current-year days and works in the opposite direction: staying under that one is a precondition to escaping residency. Conflating the two inverts the answer. Meeting this test is also not the end of the enquiry, because the closer-connection exception can unmeet it, and days excluded under §7701(b)(3)(D) and §7701(b)(7) never entered the sum at all.26 U.S.C. §7701(b)

A day of physical presence is a whole day: §7701(b)(7)(A) counts an individual as present “if such individual is physically present in the United States at any time during such day”, so a brief stop is a full day. Four provisions subtract from that baseline. §7701(b)(3)(D)(ii) removes a day on which the individual “was unable to leave the United States on such day because of a medical condition which arose while such individual was present in the United States” — the condition must have arisen here, so a pre-existing one that worsens is outside it. §7701(b)(7)(B) removes a day on which an individual “regularly commutes to employment (or self-employment) in the United States from a place of residence in Canada or Mexico”. §7701(b)(7)(C) removes a day on which an individual in transit between two points outside the United States is physically present “for less than 24 hours”, so repeated connections through a US airport add no days at all. And §7701(b)(7)(D) removes a day for a regular crew member of a foreign vessel engaged in transportation between the United States and a foreign country or a possession, “unless such individual otherwise engages in any trade or business in the United States on such day”, which is a condition rather than a gloss. These are days that never enter the arithmetic, which is a different mechanism from the closer-connection exception — that one leaves the days in the sum and negates the conclusion instead.26 U.S.C. §7701(b)

§7701(b)(3)(D)(i) does not discount an exempt individual’s days or weight them to nothing; it provides that the individual “shall not be treated as being present in the United States” on such a day. The day never enters the weighted sum, in the current-year term or in either preceding-year term — a student in year four does not have a small number, they have no number. Who is exempt is a closed list of four at §7701(b)(5)(A): a foreign government-related individual; a teacher or trainee temporarily present under subparagraph (J) or (Q) of §101(15) of the Immigration and Nationality Act other than as a student; a student temporarily present under subparagraph (F) or (M), or under (J) or (Q) as a student; and a professional athlete temporarily present to compete in a charitable sports event. Because the list is closed, everyone outside it is present in the ordinary way, and the categories are statutory rather than visa classes — a J visa holder present as a student is a student here and one who is not is a teacher or trainee, and it is the category and not the visa letter that selects the limitation. Two limitations apply, and neither is a “first N years” rule. Under §7701(b)(5)(E)(ii) a student ceases to be exempt “for any calendar year after the 5th calendar year for which an individual was an exempt individual” as a student or as a teacher or trainee — a cumulative count wherever those years fall, on a counter shared between the two categories, so years spent in one consume the other’s allowance — and it is rebuttable, since the individual remains exempt on establishing to the Secretary’s satisfaction both that they do not intend to reside permanently in the United States and that they still meet §7701(b)(5)(D)(ii). Under §7701(b)(5)(E)(i) a teacher or trainee ceases to be exempt where they were exempt “for any 2 calendar years during the preceding 6 calendar years”, a rolling lookback rather than a fixed opening period, with “4 calendar years” substituted for “2 calendar years” where all of the individual’s compensation is described in §872(b)(3). Any part of a calendar year spends the whole year.26 U.S.C. §7701(b)

Two of the rows below are the same figure and neither can be substituted for the other. One is a weighted three-year total that makes a person a resident; the other is an unweighted count of this year's actual days, below which a way out stays open. They sit one paragraph apart in the statute, and reading either as the other inverts the answer.

§7701(b)(3)(B) is an exception to the conclusion rather than an exclusion of days: the days still count, the weighted sum still clears the threshold, and the individual is nevertheless “not ... treated as meeting” the substantial presence test where two things hold together. The first is that the individual “is present in the United States on fewer than 183 days during the current year” — actual current-year days, unweighted, and a different figure from the weighted three-year total that produced residency in the first place. Someone physically present 200 days this year cannot use the exception however strong the foreign ties, and someone at 182 may, even with a weighted sum far above. The second is that it be established that for the current year the individual has a tax home in a foreign country, as defined in §911(d)(3) without regard to the second sentence of that provision, and “a closer connection to such foreign country than to the United States.” §7701(b)(3)(C) then switches the exception off entirely for anyone who at any time during the year “had an application for adjustment of status pending” or “took other steps to apply for status as a lawful permanent resident of the United States” — so an individual pursuing permanent residence is barred from the position, and “other steps” is wider than a filed application.26 U.S.C. §7701(b)

The sentence closing §7701(b)(6) ends lawful permanent resident status on three conditions, and they are conjunctive: the individual “commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country”, “does not waive the benefits of such treaty applicable to residents of the foreign country”, and “notifies the Secretary of the commencement of such treatment.” The notification is a condition of the cessation rather than a formality that follows it, so a treaty position taken and never reported has not met the third. And the sentence ends that one status. §7701(b)(1)(A) has three independent clauses and this reaches only the first, so an individual who takes a tie-breaker position and is also present enough to meet the substantial presence test of the second remains a US resident. Becoming a nonresident alien requires all three of those clauses to fail.26 U.S.C. §7701(b)

§7701(b)(4) is the third way of being a resident rather than a planning device alongside the other two, and it sets four conditions that must hold together: the individual is not a resident under the green card or substantial presence clauses for the election year; was not a resident under §7701(b)(1)(A) for the preceding year; is a resident by substantial presence for the year following; and was “present in the United States for a period of at least 31 consecutive days in the election year” and present for at least 75 percent of the days in the testing period running from the first day of that block to the end of the year, with absences “not exceeding 5 days in the aggregate” forgiven. Residency does not begin on the arrival date. §7701(b)(4)(C) begins it “on the 1st day of the earliest testing period during such year” that satisfies that fourth condition — the first day of a qualifying block of consecutive days — so someone who lands, leaves for a month and returns does not start on the day they landed. And the election cannot be made when the return is ordinarily due: §7701(b)(4)(E) requires it to be made on the election-year return, and provides that it “may not be made before the individual has met the substantial presence test ... with respect to the calendar year immediately following the election year”, a condition that matures after that return’s ordinary due date. Days excluded because the individual is an exempt individual are excluded from these counts too, and once made the election remains in effect for the election year unless revoked with the Secretary’s consent.26 U.S.C. §7701(b)

§7701(b)(2) makes residency a period rather than a yes or no for the calendar year. An individual who is a resident this year and was not a resident at any time in the preceding year is treated as a resident “only for the portion of such calendar year which begins on the residency starting date”, and which date that is depends on the clause that made them a resident: the first day of presence in the year while a lawful permanent resident, for a green card holder not meeting substantial presence; the first day of presence in the year, for one meeting substantial presence; and the day fixed by §7701(b)(4)(C), for the first-year election. Residency ends before the year does only where three conditions all hold — the portion falls after the last day of presence, or for a lawful permanent resident after the last day of that status; “during such portion the individual has a closer connection to a foreign country than to the United States”; and “the individual is not a resident of the United States at any time during the next calendar year.” That third condition is retrospective: it cannot be known when the return is prepared, and a return to the United States the following year unwinds the position. Up to 10 days of presence are disregarded for two of those determinations where a closer connection to a foreign country is established for the period. This bears directly on an S corporation, because §1361(b)(1)(C) is not an annual snapshot and §1362(d)(2)(B) makes a termination effective on the date of cessation — so the day residency begins or ends is the day an election survives or does not.26 U.S.C. §7701(b)

Trusts

A trust is not an eligible shareholder because it is a trust, because it is irrevocable, or because everyone who benefits from it is a US citizen. It is eligible because it is on a closed list and has made whatever election that list requires. The ordinary intuition runs wrong in both directions here, which is why the first three statements below travel together.

§1361(c)(2)(A) opens “For purposes of subsection (b)(1)(B), the following trusts may be shareholders:” and then names six. A trust is not eligible because it is a trust, because it is irrevocable, or because everyone who benefits from it is a US individual; it is eligible because it is on the list. The six are a trust all of which is treated under subpart E as owned by an individual who is a citizen or resident of the United States; a trust that was such a trust immediately before the deemed owner’s death and continues after it, for a bounded period; a trust holding stock transferred to it under the terms of a will, for a bounded period; a trust created primarily to exercise the voting power of stock transferred to it; an electing small business trust; and an individual retirement account, only where the corporation is a bank or a depository institution holding company and only to the extent of stock held as of the enactment of that clause. A qualified subchapter S trust reaches the list by deeming rather than as a seventh entry — §1361(d)(1)(A) provides that where the beneficiary makes the election “such trust shall be treated as a trust described in subsection (c)(2)(A)(i)”, which is also why it is the beneficiary and not the trustee who elects. And the subparagraph closes with a sentence reaching all six clauses: “This subparagraph shall not apply to any foreign trust.”26 U.S.C. §1361

A foreign trust is never an eligible S corporation shareholder, and the fence is a single sentence of flush text closing §1361(c)(2)(A): “This subparagraph shall not apply to any foreign trust.” It reaches all six clauses of that list and not merely the electing small business trust, so a grantor trust or a voting trust fails for being foreign exactly as an ESBT does. Since §1361(b)(1)(B) admits a trust only where it is “a trust described in subsection (c)(2)”, no foreign trust is such a trust, and one holding the stock is an ineligible shareholder. Reg. §1.1361-1(h)(2) states the conclusion the statute leaves to be assembled: “in any case where stock is held by a foreign trust as defined in section 7701(a)(31), the trust is considered to be the shareholder and is an ineligible shareholder. Thus, even if a foreign trust qualifies as a subpart E trust (e.g., a qualified voting trust), any corporation in which the trust holds stock does not qualify as a small business corporation.” The ordinary intuition runs wrong in both directions here: a domestic trust with a nonresident alien beneficiary works, and a foreign trust with US beneficiaries does not. What makes a trust foreign is defined at §7701(a)(31) and is not stated here.26 U.S.C. §1361 · Treas. Reg. §1.1361-1

Two of the trusts on §1361(c)(2)(A)’s list are permitted shareholders only for a period, and the two periods are the same length and begin on different days. A trust that was a grantor trust immediately before the deemed owner’s death is eligible “only for the 2-year period beginning on the day of the deemed owner’s death”, §1361(c)(2)(A)(ii). A trust holding stock transferred to it under the terms of a will is eligible “only for the 2-year period beginning on the day on which such stock is transferred to it”, §1361(c)(2)(A)(iii). Running both off one clock understates the first by the whole length of the estate’s administration, because that period has been running since the death and not since the trustee took the shares. During each window the shareholder being tested is an estate rather than the trust: §1361(c)(2)(B)(ii) treats the estate of the deemed owner as the shareholder, and (B)(iii) the estate of the testator. The clauses confer eligibility for the period and say nothing about what follows it, and neither requires the filing of anything.26 U.S.C. §1361

Two of the eligible trusts are permitted shareholders only for a period, and beyond it a trust holding the stock has to qualify under some other part of the list. In practice that means one of two regimes, each with its own requirements, its own election and its own consequences. What follows sets out what each one demands. Which of them suits a particular family is a judgment about that family, not a rule, and nothing here decides it.

The two commonest trusts in practice close the door that the electing small business trust opens, and both do it in the same words. §1361(c)(2)(A)(i) admits a grantor trust as a shareholder only where all of it is treated under subpart E as owned by “an individual who is a citizen or resident of the United States.” §1361(d)(3)(B) requires a qualified subchapter S trust to distribute all of its income currently “to 1 individual who is a citizen or resident of the United States.” So a nonresident parent who funds a US revocable trust with S corporation stock fails the first, and a US trust that pays its income to a nonresident child fails the second — both things families actually do. The statutory phrase is “citizen or resident of the United States”, and who is a resident is answered by §7701(b).26 U.S.C. §1361

§1361(d)(3) sets five requirements for a qualified subchapter S trust, and four of them are terms the trust instrument must contain: during the life of the current income beneficiary there is to be only one income beneficiary; any corpus distributed during that beneficiary’s life may be distributed only to that beneficiary; the income interest terminates on the earlier of that beneficiary’s death or the termination of the trust; and if the trust terminates during that beneficiary’s life it distributes all of its assets to that beneficiary. The fifth, §1361(d)(3)(B), is about conduct rather than drafting — all of the income within the meaning of §643(b) is distributed, or required to be distributed, currently to one individual who is a citizen or resident of the United States. The corpus requirement is the one ordinary family trusts fail: a remainder to grandchildren or a power to sprinkle corpus among siblings breaks it, and because the requirement is on the terms of the instrument, a power that has never been exercised breaks it just the same. The election is made by the beneficiary and not by the trustee, §1361(d)(2)(A); it is made separately for each corporation; it binds each successive income beneficiary unless that beneficiary affirmatively refuses; and once made it is revocable only with the Secretary’s consent.26 U.S.C. §1361

A QSST election has a filing deadline, the period is short, and it is set by regulation under an express delegation: §1361(d)(2)(B)(iii) provides that an election “shall be made in such manner and form, and at such time, as the Secretary may prescribe.” Reg. §1.1361-1(j)(6)(iii) prescribes one period and four different days for it to begin on, and the day it begins is where a real trust goes wrong. Where S corporation stock is transferred to the trust, the period runs from the day of the transfer. Where the trust already holds the stock and the corporation elects, it runs from the day the S election is effective where that is the first day of the year of election, and from the day the S election is made where it is effective for the following year. Where the trust ceases to be a qualified subpart E trust, it runs from the day it ceases — or, where the deemed owner’s estate is treated as the shareholder, from the day the estate ceases to be so treated, and the election may be filed at any time before that day. And for a testamentary trust it runs from the day after the end of the two-year period of §1361(c)(2)(A)(iii). The last two are the ones missed: one fires when a grantor dies, which nobody experiences as a filing trigger, and one two years after a death, by which time the file is closed.26 U.S.C. §1361 · Treas. Reg. §1.1361-1

§1361(d)(2)(D), captioned “Grace period”, answers how far back a filed election reaches and not by when it must be filed. It allows an election to be given an effective date earlier than the day it is made, up to a bound the subsection states, and the operative words are “up to” — a ceiling within which the beneficiary chooses a date, not an automatic backdating rule. Because it moves the effective date and not the due date, it is worth nothing to a beneficiary who has already missed the filing deadline the regulations set.26 U.S.C. §1361

Missing the QSST election deadline costs the corporation its S election rather than merely inconveniencing the trust, and the route back belongs to the corporation. Reg. §1.1361-1(j)(6)(iii)(E): “If a corporation’s S election terminates because of a late QSST election, the corporation may request inadvertent termination relief under section 1362(f).” The person who missed the date is not the person who has to fix it, and every other shareholder is exposed to it. The standard is inadvertence and not reasonable cause, and Rev. Proc. 2013-30 §4.03(1) draws that line in a single sentence, requiring a statement describing “(i) its reasonable cause for failure to timely file the Election Under Subchapter S (in the case of late S corporation or QSub elections) or that the failure to timely file the Election Under Subchapter S was inadvertent (in the case of late QSST or ESBT elections)”. That simplified administrative route runs alongside §1362(f) itself and closes after a bounded period measured from the effective date. None of it is automatic: §1362(f) turns on the Secretary’s determination and on the four conditions that subsection sets, and the simplified route requires a statement signed under penalties of perjury.Treas. Reg. §1.1361-1 · 26 U.S.C. §1362(d), (e), (f), (g) · Rev. Proc. 2013-30, 2013-36 I.R.B. 173, §§4.01(2), 4.02(2), 4.02(4), 4.03(1), 6.01

The electing small business trust is the other regime. It admits beneficiaries the qualified subchapter S trust cannot, including the one this page's readers ask about most — and it is taxed differently for it.

§1361(e)(1)(A)(i) makes a trust an electing small business trust only if it “does not have as a beneficiary any person other than (I) an individual, (II) an estate, (III) an organization described in paragraph (2), (3), (4), or (5) of section 170(c), or (IV) an organization described in section 170(c)(1) which holds a contingent interest in such trust and is not a potential current beneficiary.” Another closed list, and its last entry is not a charity at all — §170(c)(1) is a State, a possession, a political subdivision or the United States — and it is admitted only on two further conditions that entry (III) does not carry. §1361(e)(1)(B) then excludes three trusts from ESBT status outright: a qualified subchapter S trust for which an election under §1361(d)(2) applies to any corporation whose stock the trust holds, any trust exempt from tax under this subtitle, and any charitable remainder annuity trust or charitable remainder unitrust as defined in §664(d). The first of those makes the two regimes exclusive of one another for a given corporation rather than cumulative. And “potential current beneficiary” is a defined term rather than a synonym for beneficiary: §1361(e)(2) reaches any person who at any time during the period “is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the trust”, determined without regard to a power of appointment that remains unexercised at the end of the period.26 U.S.C. §1361

§1361(e)(1)(A)(ii) makes a trust an electing small business trust only if “no interest in such trust was acquired by purchase”, and the line is drawn at the interest in the trust rather than at the stock. §1361(e)(1)(C) defines the term: “purchase” means “any acquisition if the basis of the property acquired is determined under section 1012”, so the question is whether the acquirer takes a cost basis, and someone who inherits a beneficial interest or receives it by gift has not purchased it. Reg. §1.1361-1(m)(1)(iii) states the other half in terms: “The trust itself may acquire S corporation stock or other property by purchase or in a part-gift, part-sale transaction.” So the trust may buy the shares; what it may not have is a beneficiary who bought their way in — including, under the same paragraph, by way of a net gift on which the person acquiring the interest pays the gift tax.26 U.S.C. §1361 · Treas. Reg. §1.1361-1

A nonresident alien may be a beneficiary, and a potential current beneficiary, of a domestic electing small business trust that holds S corporation stock. §1361(e)(1)(A)(i) admits “an individual” as an ESBT beneficiary without qualification. §1361(c)(2)(B)(v) treats each potential current beneficiary of an ESBT as a shareholder for purposes of §1361(b)(1) and then ends: “This clause shall not apply for purposes of subsection (b)(1)(C).” Reg. §1.1361-1(m)(1)(ii)(D) says the same directly — “A nonresident alien (NRA), as defined in section 7701(b)(1)(B), is an eligible beneficiary of an ESBT and an eligible potential current beneficiary.” This is not an exception to §1361(b)(1)(C), which stands in full force; the beneficiary is simply never treated as a shareholder for that clause’s purposes. Two limits travel with the answer. The beneficiary still counts toward the 100-shareholder limit, because Reg. §1.1361-1(m)(4)(i) applies the deeming rule for §1361(b)(1)(A) and withholds it only for §1361(b)(1)(C). And the trust must be domestic: §1361(c)(2)(A) ends “This subparagraph shall not apply to any foreign trust”, so a family trust sitting abroad fails whatever the residence of the people who benefit from it.26 U.S.C. §1361 · Treas. Reg. §1.1361-1

§641(c)(1)(A) treats “the portion of any electing small business trust which consists of stock in 1 or more S corporations” as a separate trust, while Reg. §1.641(c)-1(a) keeps the trust single “for administrative purposes, such as having one taxpayer identification number and filing one tax return”. §641(c)(2)(A) then taxes that S portion “by using the highest rate of tax set forth in section 1(e)” — flat from the first dollar rather than through the graduated trust brackets, so no part of the S portion’s income runs up through a lower one. The subsection opens “Except as provided in section 1(h)”, and that exception is not marginal here: net capital gain in the S portion is taxed at the §1(h) rates, and §641(c)(2)(C)(ii) draws gain or loss on the disposition of the S corporation stock into the S portion — which is the transaction a family selling the company is most likely to be asking about. §641(c)(2)(C) is a closed list of the items the S portion takes into account, and its closing sentence does the rest of the work: “No deduction or credit shall be allowed for any amount not described in this paragraph, and no item described in this paragraph shall be apportioned to any beneficiary.” The income is not carried out to the beneficiaries, so distributing the cash does not move the tax into their brackets. §641(c)(2)(B) sets the §55(d) exemption amount for the S portion at zero.26 U.S.C. §641(c) · 26 U.S.C. §1(e), (f)(2), (h), (j) · Treas. Reg. §1.641(c)-1 · Rev. Proc. 2025-32, 2025-45 I.R.B., §§2.01, 4.01, 4.24

What happens when it breaks

This is the part the shorthand gets wrong, and the shorthand is frightening in the wrong direction. Nothing unwinds to the first of the year, and nothing is refiled from scratch. One taxable year becomes two short ones, on either side of a single day, with two returns and two regimes inside one calendar year.

§1362(d)(2)(A) terminates an S election “whenever (at any time on or after the 1st day of the 1st taxable year for which the corporation is an S corporation) such corporation ceases to be a small business corporation”, and §1362(d)(2)(B) fixes when that bites: “Any termination under this paragraph shall be effective on and after the date of cessation.” The election ends on the day it broke, not on the day anyone notices, and not at the start of the year. Nothing is filed and nothing is elected — the statute says the election “shall be terminated” — so the corporation carries on filing as an S corporation for a stretch in which it was not one, which is exactly why the failure is silent. The parenthesis marks a real boundary: a corporation that never satisfied §1361(b) in the first place had no effective election to terminate, and stands on a different footing from one that qualified and later stopped. The statute says “the date of cessation” and defines it no further.26 U.S.C. §1362(d), (e), (f), (g)

A termination taking effect during the year does not unwind the year; it splits it. §1362(e)(4) defines an “S termination year” as a taxable year in which a termination takes effect “(other than on the 1st day thereof)” — a termination effective on day one produces no split, and the whole year is simply a C year. §1362(e)(1) then makes two short taxable years out of the one: the portion “ending before the 1st day for which the termination is effective” is a short year for which the corporation is an S corporation, and the portion “beginning on such 1st day” is a short year for which it is a C corporation. Two returns and two regimes inside one calendar year. §1362(e)(2) allocates the items by an equal daily portion — per day, not per share and not by where the income arose — and that is not unconditional: §1362(e)(6)(D) switches pro rata allocation off automatically where a large enough proportion of the stock is sold or exchanged during the year, which is a fact pattern that often arrives with the termination itself, and §1362(e)(6)(C) does the same for items resulting from §338. §1362(e)(3) offers an elective escape whose consent requirement is asymmetric: every person who was a shareholder “at any time during” the S short year, and every person who is a shareholder “on the first day” of the C short year, must consent — so a shareholder who sold out in March holds a veto, and a buyer who arrives in November need not be asked. §1362(e)(5) annualises the C short year’s income so that a short period is not taxed as though it were a small year, and §1362(e)(6)(B) makes the S short year’s return due when the C short year’s return is due, extensions included.26 U.S.C. §1362(d), (e), (f), (g)

There is a way back, and a door that shuts behind. They are not alternatives — the first is a determination made by the Secretary on conditions that must all hold, and the second applies to every termination under §1362(d) whether the corporation meant it or not.

§1362(f) supplies a route back, on four conjunctive conditions, two of which are determinations by the Secretary rather than facts a taxpayer can establish. The election must either have been ineffective for the year for which it was made “by reason of a failure to meet the requirements of section 1361(b) or to obtain shareholder consents”, or have been terminated under paragraph (2) or (3) of §1362(d) or under §1361(b)(3)(C) — the first door for a corporation that was never an S corporation, the second for one that qualified and later stopped, and neither for a voluntary revocation. The Secretary must determine “that the circumstances resulting in such ineffectiveness or termination were inadvertent”. Steps must have been taken, “no later than a reasonable period of time after discovery of the circumstances”, so that the corporation is a small business corporation or the required consents are obtained. And the corporation “and each person who was a shareholder in such corporation at any time during the period specified pursuant to this subsection” must agree to make such adjustments as the Secretary requires — every shareholder in the period, including the one who caused the problem and the one who sold out and left, each holding a veto over relief for all of them, and each agreeing to adjustments not yet specified. Where all four are met the corporation “shall be treated as an S corporation ... during the period specified by the Secretary”: retrospective treatment over a period the Secretary defines, rather than a reinstatement going forward or a waiver of the defect. “Inadvertent” is the Secretary’s determination under the second condition and not a self-assessment.26 U.S.C. §1362(d), (e), (f), (g)

§1362(g) locks the door behind a termination. A corporation whose election has been terminated under §1362(d), “and any successor corporation”, may not make a new election “for any taxable year before its 5th taxable year which begins after the 1st taxable year for which such termination is effective, unless the Secretary consents to such election.” Three things a paraphrase loses. It reaches all three paragraphs of §1362(d) — voluntary revocation as much as cessation and passive investment income — so it catches a corporation that gave up S status on purpose. “And any successor corporation” closes the reincorporation route. And the clock is counted in taxable years measured from the year of termination rather than from the date of cessation, so how much calendar time actually passes depends on where in the year the termination fell. The lockout is defeasible, since the Secretary may consent; the standards applied to that consent are in the regulations and are not stated here.26 U.S.C. §1362(d), (e), (f), (g)

What this guide does not answer

Every statement above rests on a verified record, and where there is no record this page says so rather than closing the gap with an inference. Several of the questions below are the ones a reader asks immediately after reading this page. None of them is settled here, and nothing in this list rests on a source behind this guide — bring them to us with the facts of the particular company.

• What you have to pay yourself. Reasonable compensation for a shareholder-employee is the first thing most readers ask next, and it is the question this page is least able to answer: no source behind it addresses the subject at all. Nothing above should be read as saying anything about how an owner is paid.
• Whether the federal election reaches your state return. This page is federal throughout. New York runs its own S election, on its own form, and New Jersey has changed how it treats one — a federal Form 2553 settles neither of them, and a corporation can be an S corporation for federal purposes and not for state purposes at the same time. No record behind this page states what either state requires, so nothing here should be read as doing so, and no year, form or deadline for either is published above.
• Whether your LLC is a problem. §1361 never uses the word. It speaks of persons, individuals, estates, trusts, organizations and corporations, and the route from "an LLC" to one of those runs through the entity classification regulations, which no record behind this page cites. The answer is not the same for a single-member LLC and a multi-member one, and this guide gives neither.
• What makes a corporation "domestic", or a trust "foreign". Both terms appear in the statements above and both are decisive — a corporation that is not domestic cannot elect at all, and a foreign trust is never an eligible shareholder. Each is defined elsewhere in §7701 and neither definition is behind this page. Do not infer either from where a business trades, where its assets sit, or where a family lives.
• Whether a particular difference between shares is a second class. §1361 contains the prohibition and one carve-out for voting differences among common stock. The affirmative test — what makes shares one class rather than two — is in the regulations, and no record behind this page carries it. So a disproportionate distribution, a preferred return or a side agreement is not decided above, in either direction.
• Where "the date of cessation" actually falls. The statute uses the phrase and defines it no further, and it is the date everything else runs from. A closed trust window, a share transfer and an estate held open past a reasonable administration period are three different determinations, and only the first is clean.
• How long an estate may hold the stock. The period is a facts-and-circumstances question with no number in it, decided by a regulation no record behind this page cites. The failure is silent when it arrives, which is what makes it worth asking about before it does.
• How relief is actually sought, and what consent turns on. §1362(f) says the Secretary determines and stops there; §1362(g) says the Secretary may consent and stops there. The procedure, the evidence and the standards live in regulations and revenue procedures not behind this page, so nothing here offers a route, a timeline, a cost or a likelihood.
• Which trust regime to choose. The requirements of each are set out above. Which one is right for a particular family turns on facts about that family and on consequences no source behind this page states, and no record here asserts a preference between them.

Last verified: 2026-09-08