Key Takeaways

  • S corporations allow family members to be treated as a single shareholder under the "family shareholder election" for the purposes of the 100-shareholder limit.
  • A "family" for this purpose includes a common ancestor, all lineal descendants, and their spouses (and former spouses).
  • The family shareholder election is a vital strategy for families to maintain their S corporation status while exceeding the individual shareholder limits.
  • The election is generally permanent until terminated by the family or changes in status, such as divorce or the death of family members.
  • Spouses are considered as one shareholder when married, but divorce can lead to each spouse being counted separately unless they qualify under the family shareholder rules.

Under S corporation ownership rules, a company is technically a regular C corporation that has made a formal election with the IRS to be taxed as a pass-through entity. Instead of taxing its income at the corporate level and then again at the shareholder level, S corporations pass the tax liability through to the shareholders, who report it on their individual returns.

What Are S Corporations?

S corporations are created as C corporations initially by filing Articles of Incorporation with the Secretary of State's office. They issue stock and are treated very much like a regular corporation, complete with officers, directors, and shareholders. Owners are afforded the same liability protections as C corporations. This means that, except in very rare circumstances, an S corporation shareholder's personal assets cannot be used to satisfy company debts and liabilities.

S corporations aren't subject to double taxation, unlike C corporations, which are taxed at both the corporate and shareholder level on company income.

S corporations don't pay federal taxes at the corporate level in all states that follow federal rules. Income and/or losses pass through to the shareholders. This means losses might offset other income on shareholders' returns.

Who Can Be an S Corporation Shareholder?

S corporations cannot have more than 100 shareholders. However, recent changes to the law allow for family members to be declared as one shareholder. There is no maximum to the number of family members this applies to. A family can include all descendants from one ancestor, going back no more than six generations. This also includes descendants' spouses.

Per the IRS, only certain individuals and a limited number of trusts and estates are eligible to be shareholders. Eligible shareholders in an S corporation include:

  • Some voting trusts and qualified S trusts.
  • Single-member LLCs owned by U.S. citizens or permanent residents.

Certain "people" are ineligible to be shareholders in an S corporation. These include:

  • C corporations.
  • Partnerships.
  • Nonresident aliens.
  • Multiple member LLCs.
  • Foreign trusts.
  • LLPs.
  • Individual retirement accounts.
  • Business trusts.

Trusts that have individual beneficiaries are allowed to have shares in an S corporation. Tax-exempt nonprofits are allowed to be shareholders. The estate of a deceased individual who was an S corporation shareholder prior to death can maintain ownership through probate.

The IRS doesn't allow any other type of corporation to be a stockholder in an S corporation. If an S corporation issued stock to someone who is technically ineligible, it could compromise the entire S corporation status.

S Corporation Family Shareholder Rules

Under the S corporation rules, families can elect to be treated as a single shareholder for the purpose of the 100-shareholder limitation. This election allows multiple family members to hold shares in the S corporation without counting separately toward the shareholder limit. For this purpose, a "family" is defined to include a common ancestor, all lineal descendants of that ancestor, and the spouses and former spouses of these family members.

Once a family elects to be treated as one shareholder, this election remains in effect until it is expressly terminated by the family. However, a few important limitations apply:

  • The "family" election is restricted to six generations.
  • Spouses and former spouses are considered to be the same generation as the person to whom they were or are married .

Additionally, the family election can help prevent the loss of S corporation status due to exceeding the 100-shareholder limit in case of divorces or other familial changes. For instance, if a couple divorces, each spouse is considered a separate shareholder unless the family election applies.

Rules for S Corporation Ownership

It's important for S corporations to comply with all rules and procedures of the Internal Revenue Code. You should consider retaining a qualified attorney to help you organize and manage your S corporation properly.

S corporations can only have one class of stock. They cannot issue some shares that pay guaranteed dividends or some that get first rights in a liquidation. Voting rights is one exception, however. Ownership rules are not violated if some shares come with voting rights while others do not. For example, let's say you transferred some shares of stock to your children, but you aren't ready to give up your voting rights.

If even one owner is ineligible, the S corporation's status will get revoked, as it no longer qualifies to be a small-business corporation. Once S corporation status is revoked, the business cannot reapply for S corporation status for at least five years.

Impact of Divorce and Death on Family Shareholders

Divorce and death can complicate the family shareholder rules. If a married couple jointly owns shares in an S corporation and they divorce, each spouse will be treated as an individual shareholder, potentially violating the 100-shareholder rule unless they qualify for the family shareholder election. Similarly, if one spouse passes away, the surviving spouse and the deceased spouse's estate may still be treated as one shareholder under the family election

S Corporation Taxation

S corporations are not taxed at corporate rates. Typically, an S corporation does not pay any federal income tax per the IRS, except on passive income and specific capital gains.

The S corporation's business profits are subject to individual rates on each shareholder's IRS Form 1040. This means the income is only taxed once, at the shareholder level. This is how S corporations escape being subject to double taxation on profits.

S corporations have the option to keep net profits as operating capital or pay dividends to shareholders. Either way, all profits are still treated as though they were distributed to shareholders. This means a shareholder can be taxed on income he or she never actually received.

Tax Implications of Family Shareholder Elections

While the family shareholder election helps maintain the S corporation’s eligibility by limiting the shareholder count, it does not change the taxation process. The income from the S corporation is still passed through to individual family members, who report it on their personal tax returns. If the family election is revoked or changes occur, such as the death of a family member, the tax implications can vary, and careful planning may be required to avoid disruptions in the S corporation’s status.

Frequently Asked Questions

  1. What is the family shareholder election in an S corporation?
    The family shareholder election allows multiple family members to be treated as one shareholder for the purposes of the 100-shareholder limit.
  2. How does divorce affect the family shareholder rules in an S corporation?
    After a divorce, each spouse is treated as a separate shareholder unless the family election applies to maintain the combined shareholder status.
  3. Who qualifies as a "family" under the S corporation family shareholder rules?
    A family includes a common ancestor, all lineal descendants, and their spouses or former spouses.
  4. Can a family elect to be treated as one shareholder in an S corporation forever?
    The family election remains in effect unless expressly terminated, but it may be impacted by changes like divorce or the death of family members.
  5. Are there any limitations to the family shareholder election in S corporations?
    The family election is limited to six generations, and spouses and former spouses are treated as the same generation.

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