Key Takeaways

  • Only specific entities qualify as S corporation eligible shareholders, including U.S. individuals, estates, certain trusts, and qualified tax-exempt organizations.
  • 501(c)(3) organizations can own S corporation stock under strict IRS limits but must report unrelated business taxable income (UBTI).
  • The S corporation structure is limited to 100 shareholders, all of whom must be U.S. citizens or residents.
  • Corporations, partnerships, and foreign entities are not eligible S corporation shareholders.
  • Trusts such as QSSTs (Qualified Subchapter S Trusts) and ESBTs (Electing Small Business Trusts) can hold stock, but compliance requirements are strict.
  • A 501(c)(3) is not an S corporation—it is a nonprofit organization with a separate legal and tax framework.
  • Nonprofits holding S corporation stock must remain passive investors to preserve their tax-exempt status.

Eligible S corporation shareholders must be U.S. citizens or residents and must be natural/physical persons. In other words, corporations and partnerships are not eligible.

Definition of a Subchapter S Corporation

A business that passes-through profit or losses directly to shareholders is known as an S corporation. S corporations are allowed to have between one and 100 shareholders. There's a limited amount of time to notify the IRS of filing as an S corporation, so it's important to be proactive.

Eligibility Criteria for S-Corporations

Specific eligibility requirements must be met for companies to qualify as an S corporation. The business must be a corporation or entity based in the United States. In addition, one must file Form 2553 in a timely manner and meet specific requirements. For example, a business cannot have more than 100 shareholders. Consider that a wife and husband and their estate would be treated as one shareholder. A family may also choose to count all members as one shareholder.

All other individuals are to be evaluated as separate shareholders. Eligible shareholders include:

  • Individuals
  • Certain exempt organizations
  • Estates
  • Certain trusts
  • U.S. citizens or resident aliens

The business may only have one class of stock. A corporation is considered to have only one solitary class of stock if all the outstanding shares are given the same indistinguishable rights to circulation and liquidation proceeds. The following corporations are ineligible:

  • A thrift or bank institution that utilizes section 585
  • Insurance companies subject to tax under subchapter L of the Internal Revenue Code
  • Corporations that have chosen to be managed as a possessions corporation
  • A domestic international sales corporation

The business must change or adopt to one of the tax years below:

  • Ending on Dec. 31
  • A period of 12 consecutive months that ends during a low point of a business' activities
  • An ownership tax year
  • A tax year chosen following section 444
  • A 52- to 53-week tax year, as long as the fiscal year is maintained on the same basis
  • All other tax years in which the company demonstrates some sort of business purpose

Finally, all shareholders must approve to becoming an S corporation.

Additional Rules for S Corporation Eligible Shareholders

Beyond the basic formation and tax election requirements, an S corporation’s eligibility depends on maintaining the correct shareholder composition. According to IRS rules under Internal Revenue Code §1361(b), only specific categories of shareholders may hold S corporation stock. These include:

  • Individuals who are U.S. citizens or resident aliens
  • Certain estates and qualified trusts, such as QSSTs and ESBTs
  • Certain tax-exempt organizations, including 501(c)(3) entities and 501(a) organizations

An S corporation cannot have:

  • Nonresident aliens
  • Partnerships or C corporations as shareholders
  • Multiple classes of stock (though voting differences are permitted)

Maintaining compliance with these restrictions is critical—any violation can terminate S corporation status, reverting the company to C corporation taxation and potentially triggering back taxes and penalties.

Who Can Be an S Corporation Shareholder?

The guidelines regarding who can become an S corporation shareholder are determined by the manner in which taxes are charged to the corporation. Shareholders of an S corporation are permitted by the IRS to report flow-through income. This means the income and losses from the S corporation will show up on the owner's personal tax returns. S corporations are not charged taxes at the corporate level. Instead, taxes are charged to the shareholder's personal income tax returns.

The following persons are eligible to file as S corporation shareholders:

  • U.S. citizens
  • Permanent residents
  • Qualified subchapter S trusts
  • Some voting trusts
  • Testamentary trusts created by a will
  • Grantor trusts
  • Bankruptcy estates
  • Revocable trusts created as part of an estate
  • Some exempt organizations

Tax law ignores an LLC in cases where the business owner is a single member LLC, and the LLC owns an S corporation. The IRS considers the true owner of the S corporation to be the individual owner, not the LLC.

Subchapter S status is not immediately terminated when one of the other shareholders dies or falls into bankruptcy. In certain situations, it's even acceptable for an S corporation to own another S corporation. When this circumstance occurs, it's referred to as a qualified subchapter S corporation or a QSUB.

Eligible Trusts and Estate Shareholders

Trusts and estates can serve as S corporation eligible shareholders, but only specific trust types qualify under IRS regulations:

  1. Grantor Trusts – If the trust’s grantor is a U.S. individual and treated as the owner for income tax purposes, it can temporarily hold S corp stock.
  2. Qualified Subchapter S Trusts (QSSTs) – A QSST must have one income beneficiary who reports all trust income on their personal return. The beneficiary must elect QSST status within 2.5 months of receiving the shares.
  3. Electing Small Business Trusts (ESBTs) – ESBTs can have multiple beneficiaries but must file Form 2553 to make the election. The trust pays tax at the highest individual rate on its S corporation income.
  4. Testamentary Trusts – Created by a will, these trusts can hold S corporation shares for up to two years after the grantor’s death before qualifying elections are required.

Failure to meet IRS timing or qualification rules can invalidate the S election.

Individual Shareholder Requirements

Only U.S. citizens or residents are eligible to own shares in an S corporation. For example, if an S corporation was trying to raise capital and issued shares to a Canadian citizen, who was not a U.S. citizen/resident, the S corporation would be violating IRS guidelines.

Entity Shareholder Requirements

The majority of businesses, such as corporations and partnerships, are not allowed to be shareholders in an S corporation. When a shareholder dies or falls into bankruptcy, the estate may hold the S corporation stock.

Nonprofit businesses 501(c) (3) and other tax-exempt organizations 501(a) are allowed to own stock in S corporations. Despite the fact that the majority of trusts are not allowed to own stock in S corporations, certain categories (of trusts) are permitted. For example, a qualified subchapter S trust (QSST) and an electing small business trust (ESBT) are authorized to own stock in an S corporation.

Can a 501(c)(3) Be an S Corporation Shareholder?

Yes, a 501(c)(3) organization can be a shareholder in an S corporation, but there are specific limitations and considerations. While most entities, such as C corporations and partnerships, are prohibited from owning shares in an S corporation, the IRS makes an exception for certain tax-exempt organizations. This includes 501(c)(3) organizations that are recognized as public charities or private foundations.

The IRS allows 501(c)(3) organizations to be S corporation shareholders because they are exempt under section 501(a) and are explicitly listed in Internal Revenue Code §1361(c)(6) as eligible shareholders. However, their involvement must remain passive:

  • The nonprofit must not participate in the active management or daily operations of the S corporation.
  • All income derived from the S corporation is treated as unrelated business taxable income (UBTI) for the 501(c)(3), and therefore is subject to unrelated business income tax (UBIT).
  • The nonprofit must report its share of income, losses, deductions, and credits as provided on Schedule K-1 of the S corporation’s return.

Key Considerations for 501(c)(3) Shareholders:

  • The 501(c)(3) may receive income distributions, but they are taxed if considered UBTI.
  • If the nonprofit is a private foundation, additional self-dealing rules may apply.
  • Excess involvement in the S corporation may jeopardize the nonprofit’s tax-exempt status.

This arrangement is commonly used when nonprofit entities hold shares for investment purposes or receive shares as part of a donation. Legal and tax guidance is essential to avoid compliance risks, particularly around UBIT implications.

IRS Treatment of 501(c)(3) Income from S Corporations

When a 501(c)(3) owns stock in an S corporation, the IRS classifies the income as Unrelated Business Taxable Income (UBTI). This means the nonprofit must pay Unrelated Business Income Tax (UBIT) on its share of the corporation’s earnings, even though most other income may be tax-exempt.

However, the nonprofit can retain its tax-exempt status if it:

  • Keeps its involvement purely passive (no active management or control).
  • Ensures that S corporation activities do not conflict with its charitable purpose.
  • Properly reports UBTI on Form 990-T and pays the related tax.

If the nonprofit’s ownership or involvement becomes too significant, it could risk revocation of its tax exemption. Nonprofits often receive S corporation stock through donations or inheritances, in which case they may liquidate the holdings to avoid recurring UBIT liability.

Ineligible Shareholders

The following taxpayers are not allowed to own shares in an S corporation: 

  • C corporations
  • Partnerships
  • Nonresident aliens
  • Foreign trusts
  • Multiple member Limited Liability Companies
  • Limited Liability Partnerships
  • Individual Retirement Accounts

Consequences of Having an Ineligible Shareholder

If an ineligible shareholder—such as a foreign investor, corporation, or partnership—acquires S corporation stock, the IRS automatically terminates the S election as of the date the ineligible shareholder’s ownership begins. The entity immediately reverts to C corporation tax treatment, and all income thereafter is subject to corporate-level taxation.

To avoid this, corporations should:

  • Conduct regular ownership reviews to confirm shareholder eligibility.
  • Include S election protection clauses in shareholder agreements.
  • Work with tax counsel to remove or transfer ineligible ownership quickly to restore compliance

Is a 501(c)(3) an S Corporation?

The question "is a 501(c)(3) an S corporation?" reflects a common misconception. A 501(c)(3) is not an S corporation. These are two entirely different types of entities with distinct purposes and regulatory frameworks.

Key Differences:

  • A 501(c)(3) is a nonprofit organization formed for charitable, educational, religious, or similar purposes. It is recognized as tax-exempt under the Internal Revenue Code and cannot distribute profits to owners or shareholders.
  • An S corporation is a for-profit business structure that passes income, losses, deductions, and credits through to shareholders for federal tax purposes.

Because of these differences, a business cannot simultaneously be both an S corporation and a 501(c)(3). However, a nonprofit can form a separate S corporation subsidiary, or own S corporation shares if the entity is properly structured and approved by the IRS.

If an organization attempts to combine the two statuses improperly, it risks losing both its S corporation election and its tax-exempt status. Proper legal structuring and ongoing compliance are critical when nonprofits and S corporations intersect.

Structuring Relationships Between S Corporations and Nonprofits

While a 501(c)(3) cannot itself be an S corporation, it can form affiliated or subsidiary relationships to achieve shared missions:

  • A nonprofit may establish a wholly owned for-profit subsidiary taxed as an S corporation to handle commercial activities separate from its charitable operations.
  • The S corporation can contribute profits to the nonprofit as charitable donations, subject to deduction limits.
  • Alternatively, a nonprofit can invest in S corporation stock as part of a diversified portfolio, provided it complies with the IRS passive income rules.

These arrangements require careful tax planning and legal structuring to ensure compliance with both Subchapter S and Section 501(c)(3) provisions.

Frequently Asked Questions

  1. Can a foreign trust or corporation own shares in an S corporation?
    No. Only U.S. citizens, residents, qualifying trusts, and exempt organizations may own S corp shares. Foreign entities are ineligible.
  2. What happens if a 501(c)(3) earns income from an S corporation?
    It must report the income as UBTI and pay UBIT. The nonprofit remains tax-exempt if the activity is passive and properly reported.
  3. Are QSST and ESBT elections mandatory for trusts?
    Yes. A trust must elect QSST or ESBT status within the required period to maintain S corporation eligibility; otherwise, the corporation risks losing its S status.
  4. Can an IRA or retirement account own S corporation stock?
    No. IRAs and retirement plans are not permitted shareholders under IRS rules.
  5. What steps should nonprofits take before accepting S corporation stock donations?
    They should consult tax professionals, assess UBIT implications, and consider selling the stock to avoid future tax complications.

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