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.

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.

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.

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