Key Takeaways

  • A 501(c)(3) is a nonprofit tax-exempt organization and is eligible to be a shareholder in an S corporation.
  • Not all nonprofits qualify; only 501(c)(3) and certain 501(a) tax-exempt entities can hold shares.
  • A 501(c)(3) shareholder must receive passive income only and cannot control the S corporation.
  • An S corporation itself cannot be a 501(c)(3); they are fundamentally different entity types.
  • S corporations must still meet all shareholder and structural requirements to maintain their tax status.

Eligible S corporation shareholders must be U.S. citizens or residents and must be natural/physical persons. In other words, corporations and partnerships are not eligible.

Definition of a Subchapter S Corporation

A business that passes-through profit or losses directly to shareholders is known as an S corporation. S corporations are allowed to have between one and 100 shareholders. There's a limited amount of time to notify the IRS of filing as an S corporation, so it's important to be proactive.

Eligibility Criteria for S-Corporations

Specific eligibility requirements must be met for companies to qualify as an S corporation. The business must be a corporation or entity based in the United States. In addition, one must file Form 2553 in a timely manner and meet specific requirements. For example, a business cannot have more than 100 shareholders. Consider that a wife and husband and their estate would be treated as one shareholder. A family may also choose to count all members as one shareholder.

All other individuals are to be evaluated as separate shareholders. Eligible shareholders include:

  • Individuals
  • Certain exempt organizations
  • Estates
  • Certain trusts
  • U.S. citizens or resident aliens

The business may only have one class of stock. A corporation is considered to have only one solitary class of stock if all the outstanding shares are given the same indistinguishable rights to circulation and liquidation proceeds. The following corporations are ineligible:

  • A thrift or bank institution that utilizes section 585
  • Insurance companies subject to tax under subchapter L of the Internal Revenue Code
  • Corporations that have chosen to be managed as a possessions corporation
  • A domestic international sales corporation

The business must change or adopt to one of the tax years below:

  • Ending on Dec. 31
  • A period of 12 consecutive months that ends during a low point of a business' activities
  • An ownership tax year
  • A tax year chosen following section 444
  • A 52- to 53-week tax year, as long as the fiscal year is maintained on the same basis
  • All other tax years in which the company demonstrates some sort of business purpose

Finally, all shareholders must approve to becoming an S corporation.

Who Can Be an S Corporation Shareholder?

The guidelines regarding who can become an S corporation shareholder are determined by the manner in which taxes are charged to the corporation. Shareholders of an S corporation are permitted by the IRS to report flow-through income. This means the income and losses from the S corporation will show up on the owner's personal tax returns. S corporations are not charged taxes at the corporate level. Instead, taxes are charged to the shareholder's personal income tax returns.

The following persons are eligible to file as S corporation shareholders:

  • U.S. citizens
  • Permanent residents
  • Qualified subchapter S trusts
  • Some voting trusts
  • Testamentary trusts created by a will
  • Grantor trusts
  • Bankruptcy estates
  • Revocable trusts created as part of an estate
  • Some exempt organizations

Tax law ignores an LLC in cases where the business owner is a single member LLC, and the LLC owns an S corporation. The IRS considers the true owner of the S corporation to be the individual owner, not the LLC.

Subchapter S status is not immediately terminated when one of the other shareholders dies or falls into bankruptcy. In certain situations, it's even acceptable for an S corporation to own another S corporation. When this circumstance occurs, it's referred to as a qualified subchapter S corporation or a QSUB.

Individual Shareholder Requirements

Only U.S. citizens or residents are eligible to own shares in an S corporation. For example, if an S corporation was trying to raise capital and issued shares to a Canadian citizen, who was not a U.S. citizen/resident, the S corporation would be violating IRS guidelines.

Entity Shareholder Requirements

The majority of businesses, such as corporations and partnerships, are not allowed to be shareholders in an S corporation. When a shareholder dies or falls into bankruptcy, the estate may hold the S corporation stock.

Nonprofit businesses 501(c) (3) and other tax-exempt organizations 501(a) are allowed to own stock in S corporations. Despite the fact that the majority of trusts are not allowed to own stock in S corporations, certain categories (of trusts) are permitted. For example, a qualified subchapter S trust (QSST) and an electing small business trust (ESBT) are authorized to own stock in an S corporation.

Can a 501(c)(3) Be an S Corporation Shareholder?

Yes, a 501(c)(3) organization can be a shareholder in an S corporation, but there are specific limitations and considerations. While most entities, such as C corporations and partnerships, are prohibited from owning shares in an S corporation, the IRS makes an exception for certain tax-exempt organizations. This includes 501(c)(3) organizations that are recognized as public charities or private foundations.

The IRS allows 501(c)(3) organizations to be S corporation shareholders because they are exempt under section 501(a) and are explicitly listed in Internal Revenue Code §1361(c)(6) as eligible shareholders. However, their involvement must remain passive:

  • The nonprofit must not participate in the active management or daily operations of the S corporation.
  • All income derived from the S corporation is treated as unrelated business taxable income (UBTI) for the 501(c)(3), and therefore is subject to unrelated business income tax (UBIT).
  • The nonprofit must report its share of income, losses, deductions, and credits as provided on Schedule K-1 of the S corporation’s return.

Key Considerations for 501(c)(3) Shareholders:

  • The 501(c)(3) may receive income distributions, but they are taxed if considered UBTI.
  • If the nonprofit is a private foundation, additional self-dealing rules may apply.
  • Excess involvement in the S corporation may jeopardize the nonprofit’s tax-exempt status.

This arrangement is commonly used when nonprofit entities hold shares for investment purposes or receive shares as part of a donation. Legal and tax guidance is essential to avoid compliance risks, particularly around UBIT implications.

Ineligible Shareholders

The following taxpayers are not allowed to own shares in an S corporation: 

  • C corporations
  • Partnerships
  • Nonresident aliens
  • Foreign trusts
  • Multiple member Limited Liability Companies
  • Limited Liability Partnerships
  • Individual Retirement Accounts

Is a 501(c)(3) an S Corporation?

The question "is a 501(c)(3) an S corporation?" reflects a common misconception. A 501(c)(3) is not an S corporation. These are two entirely different types of entities with distinct purposes and regulatory frameworks.

Key Differences:

  • A 501(c)(3) is a nonprofit organization formed for charitable, educational, religious, or similar purposes. It is recognized as tax-exempt under the Internal Revenue Code and cannot distribute profits to owners or shareholders.
  • An S corporation is a for-profit business structure that passes income, losses, deductions, and credits through to shareholders for federal tax purposes.

Because of these differences, a business cannot simultaneously be both an S corporation and a 501(c)(3). However, a nonprofit can form a separate S corporation subsidiary, or own S corporation shares if the entity is properly structured and approved by the IRS.

If an organization attempts to combine the two statuses improperly, it risks losing both its S corporation election and its tax-exempt status. Proper legal structuring and ongoing compliance are critical when nonprofits and S corporations intersect.

Frequently Asked Questions

  1. Is a 501(c)(3) an S corporation?
    No. A 501(c)(3) is a nonprofit tax-exempt organization, while an S corporation is a for-profit entity. They serve different legal and tax purposes.
  2. Can a 501(c)(3) be a shareholder in an S corporation?
    Yes, a 501(c)(3) can own S corporation stock as a passive investor, but it must report unrelated business taxable income.
  3. Can an S corporation become a 501(c)(3)?
    No, an S corporation cannot become a 501(c)(3). They are fundamentally different entities under tax law.
  4. Will a 501(c)(3) lose its tax-exempt status if it owns S corp shares?
    Not necessarily, but it must comply with IRS rules, especially regarding unrelated business income and lack of active involvement.
  5. What tax implications does a 501(c)(3) face from S corp ownership?
    The nonprofit must pay unrelated business income tax (UBIT) on any income received from the S corporation.

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