S Corp Ownership: Everything You Need to Know
S corp ownership can be complicated it is named due to being the subchapter S of the Internal Revenue Code and was enacted by Congress in 1958.3 min read
2. Choosing S Corporation Status
3. Eligible Shareholders
4. Ownership Numbers
5. Just One Class of Shareholders
Updated November 19, 2020:
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.
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.
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.
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.
If you need help setting up your S corporation, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.