Key Takeaways

  • S corporations must follow strict shareholder rules, including a 100-shareholder limit and one class of stock.
  • Under the s corporation family shareholder rules, family members (including spouses and descendants of a common ancestor) are counted as one shareholder for the 100-shareholder limit.
  • Spouses are generally treated as one shareholder, but only if they hold shares jointly or under community property rules.
  • Trusts and estates can be shareholders, but only if they meet IRS eligibility requirements.
  • Special considerations apply during ownership transfers, especially for succession planning among family members.
  • Violations of shareholder eligibility rules may cause termination of S corporation status.

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, before 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 the 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.

Family Succession Planning and Ownership Transfers

Passing S corporation ownership to family members—through gifting, inheritance, or sale—requires careful planning to avoid violating eligibility rules. Transfers must maintain compliance with the 100-shareholder limit and only transfer shares to eligible recipients. Some key considerations:

  • Lifetime Gifts: Shares can be gifted to family members without triggering gain, but valuation and gift tax rules apply.
  • Death of a Shareholder: Shares may be inherited by family or pass through a trust or estate. Ensuring the recipient qualifies is crucial to prevent loss of S status.
  • Buy-Sell Agreements: These contracts can help define who can acquire shares upon a shareholder’s exit, maintaining eligibility among family members.

Failing to structure these transfers properly can result in loss of pass-through taxation benefits. Regular updates to ownership documents and clear communication with heirs are critical to long-term planning.

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.

Trusts and Estates in Family Shareholding

Family-owned S corporations often involve trusts or estate planning tools to transfer ownership across generations. The IRS permits certain types of trusts to qualify as S corporation shareholders, including:

  • Grantor Trusts (revocable): Treated as owned by the grantor, and thus the grantor is the shareholder.
  • Testamentary Trusts: Created by will, allowed for two years following the death of the shareholder.
  • Electing Small Business Trusts (ESBTs): Must make an ESBT election and meet IRS requirements.
  • Qualified Subchapter S Trusts (QSSTs): Requires only one current income beneficiary and an appropriate QSST election.

Proper structuring of family trusts is essential to preserve S corporation status. An ineligible trust holding even a single share can inadvertently trigger termination of the election. Families should work with legal counsel to ensure compliance during succession or gifting scenarios.

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.

Family Shareholder Rules and Spousal Ownership

The IRS allows certain related individuals to be counted as one shareholder to help family businesses qualify as S corporations. Under the s corporation family shareholder rules, all descendants of a common ancestor (within six generations) and their spouses are treated as a single shareholder for the 100-shareholder limit. This aggregation reduces the risk of exceeding the cap due to family growth.

However, spouses have special treatment depending on how shares are owned:

  • Joint Ownership or Community Property States: Spouses are treated as one shareholder.
  • Separate Property in Common Law States: Spouses may be counted separately unless they jointly elect to be treated as one shareholder.
  • Divorced or Legally Separated Spouses: May be treated as separate shareholders even if shares were once jointly owned.

The treatment of spouses becomes especially relevant in estate planning or marital dissolution. Failing to account for these distinctions could risk S corp eligibility.

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.

Frequently Asked Questions

  1. What is the 100-shareholder limit for an S corporation?
    The IRS limits S corporations to 100 shareholders, but certain family members are grouped together and counted as a single shareholder under family aggregation rules.
  2. How are spouses treated under S corporation shareholder rules?
    Spouses are typically treated as one shareholder if they own shares jointly or live in a community property state. In other cases, they may elect to be treated as one.
  3. Can a trust hold shares in an S corporation?
    Yes, but only specific types of trusts like grantor trusts, QSSTs, and ESBTs are eligible. Improper trust ownership may invalidate S status.
  4. What happens if an ineligible person receives S corp shares?
    The S corporation could lose its status and be taxed as a C corporation. This includes transfers to non-resident aliens or disqualified entities.
  5. Is it possible to transfer S corp shares to family members tax-free?
    Shares can often be gifted to family members without immediate tax, but valuation and gift tax implications must be carefully reviewed with an advisor.

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