S corporation eligible shareholders must meet a list of requirements in order to operate as this type of business entity. Once eligible, shareholders avoid what is known as double taxation. This is one of the greatest perks associated with S corporation election. Organized under the laws of the state in which you register, each shareholder must meet specific criteria. Only then can a business enjoy the benefits of S corp taxation.

What Is an S Corporation?

An S corporation is essentially a regular corporation that is limited to no more than 100 shareholders. These shareholders benefit from what's known as pass-through taxation. This means that all of the company's net losses and profits are reported on each individual shareholder's tax return, avoiding taxation at the corporate level.

Specific criteria must be met in order to be taxed as an S corporation, as stated in the Internal Revenue Code, Chapter 1, Subchapter S. During tax season, all profits are reported on each shareholder's return by filing Form 1040. In turn, this type of business entity avoids double taxation.

If you are currently operating as a corporation, you may be taxed as an S corporation as long as you meet the following criteria:

  • You must be a domestic corporation or a domestic entity that may be treated as a corporation for tax purposes. In this case, you must file Form 2553.

  • The company cannot have more than 100 shareholders. These shareholders must be individuals, certain organizations, estates, and specific trusts.

  • All shareholders must be U.S. citizens.

  • The company can only have one class of stock.

  • You are not considered an ineligible corporation, such as a bank, an insurance company, etc.

Who Can Be an S Corporation Shareholder?

Based on tax laws, S corporation shareholders must be United States citizens or permanent residents. You may also be considered an S corporation shareholder for tax purposes as a single-member LLC owner. However, you will need to meet various requirements. In special situations, an S corporation can also own an S corporation. In this case, you would be considered a qualified subchapter S corporation. ;

Who Are Ineligible Shareholders?

In contrast, those who are considered to be an ineligible shareholders are those who are defined as the following:

  • Nonresident aliens — otherwise known as a non-U.S. citizen
  • C corporations — these entities must seek election to be taxed as an S corporation
  • Partnerships — this also refers to multi-member limited liability companies
  • Individual retirement accounts
  • Foreign trusts

Since S corporations are limited to a maximum of 100 shareholders, you cannot become shareholder 101. This means that if an S corporation already has 100 shareholders, you will not be eligible. However, it is important to note that family members may be considered a single shareholder. A "family shareholder" can include the common ancestor (the grandma or grandpa), the next generation (including spouses), as well as the descendants (grandchildren).

Consequences of Violations

Being mindful of the possible consequences associated with S corp violations could determine whether or not your company succeeds. Due diligence from the get-go is imperative to your long-term success. If a prohibited individual or entity gains ownership of the company's stock, for instance, the S corporation would lose its election immediately.

For example, if you sold some of your stock to a non-resident alien, your S corporation would turn into a C corporation the day of the sale. This would occur even if you were in the middle of the tax year. Once such a violation occurs, you cannot typically seek S corp election for at least five years — even if you remedied your violation before then.

Being proactive during each step and phase of your business will help you remain in good standing. That way, you will be able to achieve sustained growth and success. On the other hand, just one mistake could be a costly move, jeopardizing all of your hard work and progress up to that point. That is why you need to be confident in each shareholder. If you are unsure about what you can and cannot do as an S corporation, ask for a professional opinion before making any drastic moves.

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