S corporation shareholders are stockholders that own shares in an S corporation company, just like shareholders in a C corporation structure. For an S corporation, taxes will occur at the shareholder level only, which makes it an attractive choice to many businesses who want to avoid double taxation. To be considered an S corporation, a business will have to meet the following eligibility requirements:

  • The corporation can have no more than 100 shareholders.
  • A shareholder must be an individual, a trust, an estate, or an exempt organization.
  • The shareholders must be legal residents of the United States.
  • The company may only distribute one class of stock (although they can offer both voting and nonvoting shares).
  • The company cannot be an ineligible company, such as a bank or insurance company.

When a company elects S corporation status, it is agreeing to limits on the type of shareholders that the company can maintain. The limitations that the IRS place on the shareholders of an S corporation primarily relate to the way in which the taxes are imposed on the corporation.

S corporation shareholders are allowed to report their income as flow-through income which can be included along with business losses on their tax return. An corporations">S corporation's taxes are only paid at the shareholder level through personal taxes on their share of the income of the company. Business income is not taxed at the corporate level, so no taxes are paid directly by the corporation.

Eligible S Corporation Shareholders

Tax law defined and enforced by the IRS will identify the eligibility requirements that shareholders must possess to qualify as S corporation shareholders for tax purposes. To be considered an eligible shareholder by the IRS, shareholders must:

  • Be United States citizens
  • Be permanent residents of the United States
  • Be either an individual, a single member LLC, a voting or testamentary trust, a bankruptcy estate, a grantor trust, a revocable trust that was created as a part of an estate, or a tax-exempt organization

In the event that an eligible S corporation shareholder dies or declares bankruptcy, the S corporation will not automatically disintegrate. The estate of the individual that owned shares of the S corporation's stock will be able to maintain ownership through the entire probate process.

In special situations, it is possible for another S corporation to be a stockholder in another S corporation. In this case, the subsidiary S corporation will be referred to as a qualified subchapter S corporation.

Ineligible S Corporation Shareholders

There are certain situations in which the IRS will deem shareholders ineligible to own shares in an S corporation. Shareholders that would be considered ineligible to own S corporation stock include:

  • Individuals considered nonresident aliens
  • C corporation entities
  • Partnerships
  • Multi-member limited liability companies
  • Individual retirement accounts'
  • Foreign trusts
  • Business trusts
  • Any shareholder that would put the total over the maximum limit of 100 (though members of a family can be treated as one shareholder)

There are some considerations where the above ineligible shareholders could partially own the S corporation. For example, while a partnership cannot own stock in an S corporation, an S corporation can be a partner in a partnership. This is sometimes used as a way for a partnership to have some interest in an S corporation.

Two S corporations that already have 100 shareholders can obtain more shareholders by forming a partnership, enabling them to be able to circumvent the shareholder limit. This same strategy can be used by a nonresident alien who wants to have an interest in an S corporation: the S corporation could form a partnership with a nonresident alien or other ineligible shareholder.

Additionally, while a C corporation cannot legally own shares of stock in an S corporation, the S corporation can own shares of a C corporation's stock. It is important to exercise caution and to be sure to follow procedure when creating agreements that might occur with otherwise ineligible stockholders. 

If an S corporation issues shares to an entity that is prohibited, the IRS can legally declare the business' S corporation status null. If this occurs, the corporation will revert back to C corporation status. This status will be backdated to when the sale of the stock occurred.

If you need help determining the eligibility of S corporation shareholders, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such  as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.