An S corporation may issue stock to its owners. However, the Internal Revenue Service imposes a significant number of restrictions on the stock issued by the S corp, which may make an S corp an ineffective business entity for certain entrepreneurs. Knowing the restrictions before you decide the entity type you want to use for your business helps you make a better decision.
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Classes of Stock
S corps may not issue more than one class of stock. For example, an S corp could not issue one class of stock that received dividends and one class of stock that did not. The IRS does make an exception to the one-class-of-stock rule if the only difference between the two classes of stock is the voting rights. For example, an S corp is permitted to have one class of stock with voting power and one class of stock without voting power. This is particularly helpful when shareholders of family-owned S corps want to begin passing ownership to their heirs, but still want to retain control of the company. For example, if a shareholder wanted to begin transferring ownership to his children to limit his estate tax, but did not want his children running the company, he could transfer non-voting stock to the children.
Number of Shareholders
An S corp cannot have more than 100 shareholders. However, the IRS allows family members to agree to be counted as one person for the purposes of this limit. A "family member" includes any lineal descendent of a common ancestor no more than six generations prior to the youngest member of the family, any spouse or prior spouse of the common ancestor, or any of the lineal descendants. For example, a husband and wife, their two children, their children's spouses, and their three grandchildren and spouses, would all be considered one shareholder as long as they agreed to be treated as one owner. To ensure that the S corp does not run afoul of this restriction, most S corps have restrictions on when shares can be sold and who may purchase the shares.
The IRS also limits who can be a shareholder in an S corp. Unlike C corporations, shareholders must be individuals that are either U.S. citizens or U.S. residents. Shareholders can also be the estate of a former shareholder, certain domestic trusts, and certain tax-exempt entities such as 501(c)(3) organizations. However, if even one shareholder does not meet the requirements, such as a U.S. resident electing to become a nonresident, the S corp no longer complies with all the S corp restrictions.
Results of Violations
If the S corp violates one of the restrictions on its stock, such as the number of shareholders or having more than one class of stock, it loses its S corp status. When an S corp loses its status, it becomes a regular C corporation, which means that the income and losses no longer flow through to the shareholders. Instead, the company must pay the corporate income tax. Losses cannot be used on the personal returns of the shareholders and any distributions from the company are taxed as dividends.