Key Takeaways

  • Shareholder Limit: An S corporation can have no more than 100 shareholders, though certain family members can be treated as one shareholder.
  • Ownership Restrictions: Only U.S. citizens and permanent residents can be shareholders. Partnerships, corporations, and most foreign entities are not eligible.
  • Stock Requirements: S corporations must have only one class of stock, but differences in voting rights are allowed.
  • Passive Income Rules: If passive income exceeds 25% of gross receipts for three consecutive years, the S corp may lose its status.
  • Entity Eligibility: Only domestic corporations and certain trusts or estates qualify to elect S corp status. Some financial institutions and insurance companies are excluded.
  • Election Process: Corporations must file IRS Form 2553 and adopt a qualifying tax year to secure S corp treatment.

The S corp shareholder requirements begin by limiting the number of shareholders allowed to only 100 for the entire company.

Overview of S Corporation Requirements

While under normal conditions only 100 shareholders are allowed to be part of an S corporation, an exception by the Internal Revenue Service allows family members to be counted as one shareholder. Family members include children and spouses.

The only people allowed to own S corporation stock are those who are either a U. S. citizen or someone who is a U.S. permanent resident. A non-resident is specifically prohibited from owning S corporation stock. If someone were to sell any of their shares of the S corporation to a non-resident, the company would lose its S corporation status.

The tax code has additional limitations of other situations that forbid owing S corporation stock. For example, corporations and partnerships are not allowed to own stock in an S corporation. Another exception involves estates. For estates involving someone who owned stock, the shares will continue to be owned by the estate. Also, a shareholder experiencing individual bankruptcy retains his shares.

Certain trusts are also eligible to own S corporation stock. Certain insurance companies and financial institutions cannot be shareholders regardless of how the business structure is organized.

S corporations have one class of stock. What this means is a corporation can't have shares of stock with different dividend rights or liquidation preferences. The IRS makes an exception by allowing shares to differ when it comes to voting rights. For example, while some shares have voting rights other shares do not, but both are still considered one class of stock.

Shareholder Qualifications and Ownership Rules

Meeting shareholder eligibility requirements is one of the most crucial aspects of S corp qualifications. The IRS imposes strict rules on who can own shares, how many shareholders are permitted, and what types of entities may participate.

Key shareholder rules include:

  • Number of Shareholders: An S corporation can have no more than 100 shareholders. However, members of the same family (such as a spouse, children, parents, or grandparents) may elect to be treated as one shareholder for this purpose, giving businesses more flexibility while staying compliant.
  • Eligible Shareholders: Only individuals who are U.S. citizens or permanent residents can own shares. Certain estates, specific types of trusts, and nonprofit organizations under IRC §501(c)(3) may also hold stock.
  • Ineligible Shareholders: Foreign individuals, partnerships, corporations, and most LLCs cannot hold ownership. If even a single disqualified entity becomes a shareholder, the company will lose its S corporation status and revert to C corporation taxation.
  • Stock Requirements: S corporations must issue only one class of stock. This means all shares must have equal rights to distributions and liquidation proceeds. However, shares may have different voting rights (e.g., voting vs. non-voting) without violating the “single class” rule.

Maintaining compliance with these ownership qualifications is critical. A single violation — such as an ineligible shareholder or issuance of preferred stock — can trigger automatic termination of S corporation status.

S Corporation Restrictions

With an S corporation, the company passes its earnings and losses to the owners. By doing so, the corporation avoids double taxation.

The S corporation structure also provides shareholders with limited liability. On the downside, if the corporation violates any of the eligibility restrictions, it will lose its S corporation status and be taxed as a regular corporation.

An S corporation can have no more than 25 percent of its income generated by passive activities. If this figure is surpassed, the extra earnings will be subject to an extra tax.

Passive activities involve those types of activities that someone does not materially participate in on a continuous, regular, and substantial basis. An example of passive income would be profits derived from interest income such as earnings from rental properties.

An S corporation that exceeds the 25 percent mark for three years in a row will have its S corporation status revoked by the Internal Revenue Service and it will be taxed as a C corporation.

Only 100 shareholders can be part of an S corporation. If this number is exceeded, the business reverts to a C corporation.

Only individual U.S. citizens or residents are eligible to own S corporation stock. Certain trusts and nonprofits are permitted as owners. If this restriction is violated and just one non-qualified owner is part of the corporation, special status is removed, and the company reverts to a C corporation.

Income Limitations and Business Activity Restrictions

Another essential aspect of S corp qualifications is the nature of the company’s income and business activities. Because S corporations are “pass-through” entities, the IRS imposes specific limits to ensure they remain closely held and actively managed.

  • Passive Income Limits: If more than 25% of a corporation’s gross receipts come from passive income (such as rents, royalties, or interest) for three consecutive years, the IRS may terminate its S corporation status. Passive income is typically defined as income derived from activities in which shareholders do not materially participate.
  • Types of Businesses Not Eligible: Certain financial institutions, insurance companies, and domestic international sales corporations (DISCs) are prohibited from electing S corporation status. Additionally, some banks and thrift institutions taxed under specific provisions of the Internal Revenue Code are automatically ineligible.
  • Business Purpose: While S corporations can engage in a wide range of business activities, they must operate as domestic entities with an active trade or business. Shell corporations or entities formed solely for investment purposes may face scrutiny during IRS review.

These restrictions are designed to maintain the S corporation’s status as a closely held, operational business rather than a passive investment vehicle.

S Corporation Eligibility

Additional Criteria

  • The company is either a domestic entity or domestic corporation eligible to file Form 2553 and be treated as a corporation.
  • In regard to the 100-shareholder limit, husbands, wives, and their estates are treated as one shareholder. A family member can opt to treat all family members as one shareholder.
  • A company cannot be an ineligible corporation.
  • Ineligible corporations include businesses such as a bank or thrift institution.
  • It is ineligible if it is an insurance company that is taxed under Subchapter L of the U.S. Code.
  • Under section 936, it is ineligible if it is a corporation opting for treatment as a possessions corporation.
  • It is ineligible if it is a current or former domestic international sales corporation.

The corporation has already adopted or changed to a specific tax year or will be changing to one of the tax years. The tax year options include:

  • December 31 as the end of the year.
  • A natural business tax year.
  • An ownership tax year.
  • A corporation electing a tax year under section 444.
  • A tax year, including 52-53-week tax years, in which the corporation has established a business purpose.

Election Process and IRS Filing Requirements

Even if a company meets all the shareholder and operational requirements, it must complete the proper IRS election process to gain S corporation status. Failure to follow these procedural steps can delay or deny the S election.

Steps to elect S corporation status:

  1. Form 2553: File IRS Form 2553, “Election by a Small Business Corporation,” signed by all shareholders, within 2 months and 15 days after the start of the tax year in which the election is to take effect.
  2. Domestic Incorporation: The entity must be a domestic corporation or an LLC that has elected to be treated as a corporation for tax purposes.
  3. Adopt an Eligible Tax Year: Most S corporations use a calendar tax year ending December 31. In some cases, they may request a different fiscal year by demonstrating a valid business purpose or electing under Section 444.
  4. Verify Shareholder Compliance: Before filing, ensure all shareholders are eligible and that the corporation meets the one-class-of-stock rule.
  5. IRS Approval: Once filed, the IRS will notify the corporation of the acceptance of its S status. If the election is rejected, the corporation will continue to be taxed as a C corporation until the issues are resolved.

Staying proactive about filing deadlines and maintaining ongoing compliance with S corporation regulations is vital to preserving the tax advantages associated with S status.

Frequently Asked Questions

  1. How many shareholders can an S corporation have?
    An S corporation can have up to 100 shareholders. Certain family members can be treated as a single shareholder to increase flexibility.
  2. Can foreign individuals own shares in an S corporation?
    No. Only U.S. citizens and lawful permanent residents may be shareholders. Foreign individuals or entities are ineligible.
  3. What happens if an S corporation issues two classes of stock?
    Issuing multiple classes of stock violates IRS rules, causing the company to lose its S corporation status and revert to C corporation taxation.
  4. What is the deadline for filing Form 2553?
    Form 2553 must be filed within 2 months and 15 days after the start of the tax year in which S status is to take effect.
  5. What if an S corporation exceeds the passive income limit?
    If passive income exceeds 25% of gross receipts for three consecutive years, the IRS can revoke the corporation’s S status.

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