What Are S Corporation Shareholder Requirements?

To be recognized by the IRS as an S corporation, the corporation must meet certain shareholder requirements. S corporations are regular corporations that elect to be taxed as a pass-through entity. Doing so solves the double-taxation problem where employees/shareholders and the corporation are both taxed on money earned by the corporation. Corporations become S corporations by filing IRS Form 2553 for a subchapter S election. To qualify, corporations must meet specific criteria, such as the types of shareholders and the number of shareholders.

Advantages of S Corporations for Shareholders

  • S corporations do not pay corporate tax rates.
  • S corporations are taxed as pass-through entities, so shareholders are not double taxed.
  • Shareholders of S corporations only pay individual tax rates on their respective earnings.

Frequently Asked Questions About S Corporation Shareholder Requirements

Who can be a shareholder in an S corporation?

Shareholders in an S corp are individuals. An individual can also include spouses that are co-owners of stock. In some cases, non-individuals, like trusts and estates, can be considered shareholders if they meet specific requirements.

For a trust to be a shareholder, it must have beneficiaries that are individuals who could take ownership of the stocks in the trust. Business trusts cannot be considered shareholders since their design prevents them from being individuals.

Estates are generally not considered to be shareholders because of their structure. However, an estate can maintain ownership of shares that passed into the estate when it was established. The estate must go to the proper probate process and the shares will eventually either be sold or pass to an owner that will become the shareholder.

What is the benefit of being an S corporation shareholder?

Shareholders in S corporations receive many of the same benefits as their counterparts at other companies. When a company turns a profit, it can distribute some or all of that profit as dividends that are paid to the shareholders. However, S corporation shareholders are only taxed once on the shareholder level since the corporation itself does not need to pay income tax.

Are there any downsides to being an S corporation shareholder?

Yes, there is one significant downside to how dividends are paid to S corporation shareholders. In an S corp, shareholders receive dividends that the company feels should be paid out from its latest profit. However, an S corporation's profit is taxed under the assumption that all of the profit was paid out as dividends, even if it wasn't. That means that shareholders will pay taxes on what their total earnings from the company would be rather than what was actually paid out. Essentially, you could end up paying taxes on money you did not receive from the company since it was reinvested in the company before it was given to you.

Which companies are automatically eligible for filing to become an S corp?

There are specific company structures and types that are not allowed to become S corporations. These include the following:

  • Banks and Thrift Institutions that use the reserve method of accounting to manage their bad debts, as outlined in Section 585 of the Internal Revenue Code.
  • Insurance companies that are affected by Subchapter L of the Internal Revenue Code.
  • Possessions Corporations outlined in Section 936 of the Internal Revenue Code.
  • Current or former DISC (Domestic International Sales Corporation) Corporations.

What are the tax year requirements for S corporations?

S corporations are required to work on the following:

  • A tax year that ends on December 31.
  • A natural business year model.
  • An ownership tax year model.
  • Any tax year model that is in Section 444 of the Internal Revenue Code.
  • A tax year with 52 to 53 weeks.

Other tax year forms can be used based on feedback from the IRS, and they are limited to those that companies can prove a need when filing.

If, at any point, the shareholders of an S corporation fail to meet the shareholder requirements, the S corporation status of the corporation is immediately administratively terminated. This means that if a person who is not a qualified shareholder gets shares in the company, that company is no longer an S corporation. It reverts back to being a C corporation immediately. This could mean with the company could not refile to be an S corp for up to five years.

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