S Corp Qualifications: Everything You Need to Know
S corp qualifications require specific eligibility criteria require that an entity's choice to be taxed as an S corp is reported to the IRS with timeframe.3 min read
2. Shareholder Eligibility Requirements
3. Individual Shareholder Requirements
4. Entity Shareholder Requirements
5. Consequences of Violations
6. Taxation of Corporations
S corp qualifications require specific eligibility criteria to be met and require that notification of an entity's choice to be taxed as an S corporation is reported to the Internal Revenue Service (IRS) within a certain timeframe.
Eligibility Criteria for S Corporations
The following criteria must be met by a corporation to be taxed as an S corporation.
- The company must be either a domestic corporation or it must be a domestic entity that is eligible to elect S corporation status that will be required to file Form 2553.
- The limit for S corporation shareholders is 100. In the case of eligibility, a husband and wife, as well as their estates, are treated as a single shareholder.
- A family member can choose for all members of his family to be treated as one shareholder. Everyone else is treated as a separate shareholder. Family members are considered descendants of a common ancestor that can be no more than six generations removed from the youngest owner at the time of the S election.
- There is one class of stock for S corporations. In general, a corporation treated as having a single class of stock occurs when the outstanding shares provide identical rights to liquidation and distribution proceeds.
- Each shareholder must consent to elect S corporation status.
To be eligible, the business cannot be an ineligible corporation such as:
- A thrift or bank institution that accounts for its bad debts under Section 585 by using the reserve method in accounting procedures.
- Under subchapter L of the code, an insurance company subject to tax.
- Under section 936, any corporation that has chosen to be treated as a possessions corporation.
- A domestic international sales corporation nor can it be a former domestic international sales corporation (DISC).
The company must have, change to, or adopt one of these tax years:
- December 31 is the year-end tax period
- Has a natural business year
- Has an ownership tax year
- The tax year was elected under section 444
- A 52 to 53-week tax year that references one of the above tax years
- Any other tax year where the business has established a business purpose -- this includes the 52-53-week tax year
Shareholder Eligibility Requirements
Individual Shareholder Requirements
The only shareholders allowed for an S corporation are certain trusts, individuals, and certain exempt organizations. There can be no non-resident aliens or citizens of foreign countries as shareholders. Only U.S. residents and resident aliens can be shareholders.
If an S corporation was to issue shares to a Canadian citizen who is not a U.S. resident, the S corporation would be in violation of the shareholder requirements.
Entity Shareholder Requirements
Entities that are prohibited as shareholders in an S corporation include corporations and partnerships. An exception would be an estate holding the shares of a deceased shareholder.
Under section 501(c)(3) nonprofit organizations and under section 501(a) tax-exempt organizations may own stock. Certain subchapter S trusts and electing small business trusts may own stock without making the S corporation election ineligible.
Consequences of Violations
If an S corporation's stock is purchased by either a prohibited business or individual, the S corporation election is immediately revoked. An example would be if a non-resident alien purchased S corporation stock. Upon this happening, the company will revert to being a C corporation on the date the sale of the stock took place regardless of what time of year the sale took place.
Once a violation of the S corporation eligibility requirements is violated, the company cannot elect to be an S corporation again for at least five years.
Taxation of Corporations
With a regular corporation, also known as a C corporation after the Internal Revenue Code for Subchapter C, businesses are taxed as a separate entity. Corporations use Form 1120 and their own C corporation tax rate when filing taxes.
A C corporation may keep their earnings and profits as a portion of the company's operating capital, or a portion of the earnings and profits may be distributed as dividends to its shareholders.
Dividends paid to shareholders are taxed at the corporate level then again at the individual level resulting in double taxation.
S corporations do not pay corporate taxes. For the most part, an S corporation is exempt from federal income tax except on certain passive income and capital gains.
An S corporation passes its profit or losses through to its shareholders, to be taxed at the individual rate.
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