S corp ownership can be complicated. An S corp, named due to being the subchapter S of the Internal Revenue Code, was enacted by Congress in 1958. It was created to encourage the creation of and support of small and family businesses. A major component was the elimination of the double taxation scheme that conventional corporations are subject to.

Characteristics

The election of an S corp places limits on the type of shareholders an S corporation may maintain, per the IRS rules. This is derived from how taxes are imposed on a corporation.

In essence, an S corporation is a regular corporation, see C corporation, that elected special tax treatment that it is treated as a pass-through entity with respect to taxes. This means that the IRS permits shareholders in an S corporation to report taxes on a “pass-through" basis, wherein income and losses of the corporation are passed to a shareholder’s individual tax return. This means that taxes are not assessed at the initial corporate level.

Permissible shareholders in an S corporation, per IRS regulations, are either individuals or trusts and estates. Other corporations cannot be shareholders in an S corporation.

Only trusts with individual beneficiaries can have shares in an S corporation. Business trusts are not permitted to own shares. Estates of the deceased who owned shares in an S corporation, prior to death, can continue to be owners via the probate process.

As mentioned, other types of corporations are prohibited from owning shares of an S corporation. What’s more, partnerships and non-resident alien individuals are barred from owning stock in an S corporation. There are no exceptions to these limitations.

Note that If an S corporation share is issued to a prohibited entity, e.g. another corporation, the IRS can declare the entire S corporation status void by the IRS. As a result, the income generated by the corporation will be taxed at both the corporate level and to the individual shareholders.

Choosing S Corporation Status

While the S corporation model has important tax advantages and provides ownership flexibility, it is not always the proper choice for every start up company due to certain restrictions. An S corporation is required to comply with the following:

  • Maximum of 100 shareholders
  • It must be a domestic, not foreign, business
  • The shareholders are required to be US citizens or have legal residence in the US
  • An S corporation is limited to one class of stock

As such, it depends on your long-term goals of the business. For instance, a company may want to be publicly traded or have international shareholders, making a C corporation, not an S corporation, as the better choice of business entity. C corporations, unlike S corporations, have no ownership limitations and can offer multiple classes of stock.

However, a U.S.-based business that can work within these limitations, would likely choose the S corporation model because it saves a lot of money and can avoid a lot of hassle when the company expands.

Eligible Shareholders

IRS rules allow US citizens and residents as eligible shareholders in an S corporation. Non-resident aliens are not permitted to be shareholders. Other corporations and partnerships are not eligible. Certain trusts and estates are eligible to hold S corporation shares. Nonprofits holding tax exempt status are permitted shareholders.

Ownership Numbers

S corporations are capped at 100 shareholders. However, a number of family members count as one shareholder, regardless of the family size. The term family, in this context, is all descendants of a common ancestor, going back six generations to the date of the application for S corporation status. Family also includes all the spouses of descendants.

This means that if a person, his or her spouse and children and grandchildren all owned stock in an S corporation, they all count as one shareholder.

Just One Class of Shareholders

Another significant limitation is that the S corporation is limited to one class of stock. To illustrate, an S corporation cannot issue a share that has a guaranteed dividend payment or first rights in the event of a liquidation. An exception to this rule regarding equal treatment of shareholders is voting rights.

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