Key Takeaways:

  • An S corporation can have no more than 100 shareholders, all of whom must be eligible owners such as U.S. citizens, certain trusts, estates, and qualifying nonprofits.
  • Ownership changes in an S corp require careful handling to maintain eligibility, including using the correct S corp change of ownership form and updating both IRS and state records.
  • Prohibited transfers—such as to non-resident aliens, partnerships, or corporations—can revoke S corp status, triggering double taxation and a five-year wait to re-elect.
  • Only one class of stock is allowed; differences in voting rights are permitted but must not affect distribution or liquidation rights.
  • Ownership changes impact Schedule K-1 allocations, which must be prorated between old and new owners for the tax year.
  • Filing procedures often involve updating shareholder agreements, preparing IRS Form 1120-S, and ensuring stock transfer records are compliant with state corporate law.
  • Legal guidance is recommended to navigate compliance issues and avoid costly mistakes.

S corp ownership rules require that a corporation must meet specific criteria to be eligible and that the notification of the choice to be taxed as an S corporation be submitted in a certain timeframe to the Internal Revenue Service (IRS).

S Corporation Ownership Rules

Number of Owners

  • A maximum of 100 shareholders is allowed in an S corporation.
  • Family members may be counted as one shareholder. Family members are considered descendants of an ancestor.
  • This includes up to six generations as of the date of election application for S corporation status. This also includes descendants and spouses.

Ownership Transfer Procedures and Required Forms

When an ownership change occurs in an S corporation, it is crucial to follow proper transfer procedures to maintain S corp status and compliance. This typically involves:

  1. Completing a Stock Transfer Agreement – This outlines the terms of the sale or transfer, the number of shares involved, and the effective date.
  2. Updating the Stock Ledger – The corporation’s stock ledger should reflect the new ownership details, including the number of shares and date of transfer.
  3. Filing an S Corp Change of Ownership Form – While there is no single IRS form solely for ownership changes, the transaction must be reflected on the next Form 1120-S filing and in state corporate filings.
  4. Notifying the IRS and State Authorities – If the ownership change results in a change in responsible parties, file IRS Form 8822-B. Certain states may require a separate notification or amended annual report.
  5. Prorating Income and Losses – Schedule K-1 allocations for the year must be split between the departing and incoming shareholders based on ownership days.

Failure to document ownership changes properly can lead to disputes among shareholders, inaccurate tax filings, and potential revocation of S corporation status.

Eligible Owners

  • An S corporation can only be comprised of eligible U.S. citizens and U.S. residents.
  • Non-resident aliens are not permitted to be shareholders in an S corporation.
  • S corporations are also limited to the types of entities allowed to own shares. Certain trusts and estates can hold S corporation shares while partnerships and other corporations may not hold S corp shares. ;
  • Trusts with individual beneficiaries are allowed to own S corporation shares. Business trusts are not permitted to be shareholders.
  • Estates of deceased shareholders of an S corporation can maintain ownership through probate.
  • Tax-exempt nonprofits are also eligible to become shareholders.
  • There are no exceptions to non-resident aliens and partnerships when it comes to not being permitted to own S corp stock.

Restrictions on Ownership Transfers

Ownership transfers must comply with S corp eligibility rules. A sale or gift of shares to an ineligible entity—such as a non-resident alien, partnership, or corporation—immediately terminates the S election. Common restrictions include:

  • No foreign owners – All shareholders must be U.S. citizens or resident aliens.
  • No multi-tier ownership – Another corporation, LLC, or partnership may not own S corp shares.
  • Trust limitations – Only specific trusts, such as grantor trusts, voting trusts, and certain qualified subchapter S trusts (QSSTs) and electing small business trusts (ESBTs), can hold shares.
  • Shareholder consent – Many bylaws or shareholder agreements require existing shareholder approval before transferring shares.

Before finalizing a transfer, confirm that the buyer or recipient meets eligibility requirements to prevent an inadvertent loss of S status.

Warning

  • If at any time S corporation shares are issued to an entity that is deemed prohibited, such as another corporation, the Internal Revenue Service will declare the S corporation election as being null and void.
  • If the S corporation status is revoked, the income will be taxed at the corporate level and again at the shareholder level.
  • The S corporation election is designed to avoid double taxation as enforced by the IRS.

Expert Assistance

  • An S corporation must be in compliance with the Internal Revenue Code and its rules and regulations, which can result in complex legal issues.
  • It is recommended that owners consult with a qualified attorney knowledgeable in business organization and management.

Effects of Violation

  • The penalty for selling even one share to an ineligible owner will result in the S corporation election being revoked because the company is no longer operating as a small-business entity.
  • There is a five-year waiting period once the S corp election is lost and the company is allowed to elect S corporation status again.

One Class of Stock

  • An S corporation can have only one class of stock. For example, an S corporation cannot have shares paying a dividend or shares that get the first rights in a liquidation.
  • Voting rights are an exception. The S corporation rules are not violated if some shares have voting rights and others do not. In other words, as an example, a shareholder may transfer some of the shares to children while retaining shares with voting rights.

Function

  • With an S corporation election, taxes are not assessed against the business at the corporate level by the IRS.
  • Shareholders of an S corporation report what is referred to as "flow-through" income and losses on individual personal tax returns.

Tax Implications of Ownership Changes

A change in ownership can significantly impact the allocation of profits, losses, and deductions for the year:

  • Prorated allocations – The IRS generally requires that income, deductions, and credits be allocated on a per-share, per-day basis between old and new owners.
  • Closing-of-the-books election – Alternatively, shareholders may agree to "close the books" on the date of transfer to allocate income and deductions more precisely. This election must be made with the IRS.
  • Reporting on Schedule K-1 – The corporation must prepare a separate Schedule K-1 for each shareholder reflecting their portion of the tax year.
  • Potential gain recognition – If a sale involves appreciated stock, the seller may realize capital gains, and the buyer’s basis in the shares will be adjusted accordingly.

Information About Forming an S Corporation

Basically, to form an S corporation a document is filed that creates an independent legal entity that operates on its own. The entity has a name, a specific purpose for the business, and a tax identification number with the IRS making it an active corporation. As such, the corporation is responsible for the operations/activities of the business. By doing so, the owners (shareholders) are protected.

The liability of an owner is limited to their initial investment to start the corporation. This does not include personal assets.

Depending upon the state law where the business is being incorporated, one or more than one person may serve as directors and officers.

The initial paperwork filed by the corporation is its articles of incorporation. The articles include the company's name, the names of the board of directors, the authorized number of shares, and other items.

The incorporator signs the articles of incorporation. This may be an individual involved in the S corporation. Often, it is the company's designated attorney.

Frequently Asked Questions

1. Is there an official IRS S corp change of ownership form? No. Ownership changes are reflected on the next Form 1120-S and Schedule K-1s. You may also need to file Form 8822-B for changes in responsible parties and comply with state filing requirements.

2. How do I prorate income after a shareholder change? You can use the IRS per-share, per-day method or elect to close the books on the transfer date to allocate income more accurately between shareholders.

3. Can I transfer S corp shares to a family trust? Yes, but only if the trust qualifies under S corp rules, such as a grantor trust, QSST, or ESBT. Otherwise, the transfer could terminate S status.

4. What happens if I transfer shares to an ineligible owner? The S election terminates immediately, subjecting the corporation to C corporation taxation. Re-election is barred for five years unless you obtain IRS consent.

5. Do I need shareholder approval before transferring my shares? Most S corp bylaws and shareholder agreements require majority or unanimous approval before any ownership change. Always review your governing documents first.

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