S Corporation Qualifications

by Michael Keenan
Many small business owners avoid double taxation by converting to an S corporation.

Many small business owners avoid double taxation by converting to an S corporation.

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Many small businesses elect to be treated as S corporations. This is often a smart business decision because with an S corporation, the income and losses from the business flow through to the owners rather than being taxed at the corporate level and then taxed a second time at the individual level. Not all businesses qualify for this election, however. The Internal Revenue Service publishes guidelines that can be used to determine whether a business is eligible to convert to an S corporation.

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Eligible Entities

To be recognized as an S corporation by the Internal Revenue Service, a business must meet certain qualifications. Only domestic corporations and domestic limited liability companies (LLCs) can elect to become S corporations. In addition, certain types of businesses, including some financial institutions, insurance firms and domestic international sales corporations, cannot make this election. For example, a Canadian LLC cannot convert to an S corporation, and a U.S. partnership would not be eligible either.

Limitations on Stock Classes

An S corporation can generally issue only one class of stock to shareholders. For example, the business cannot have one class of common stock and another class of preferred stock. The IRS allows common shares to have different voting rights, as long as that is the only difference. For example, if the owners create a second class of common shares identical to the original common shares except that the new shares have no voting rights, the company may still qualify for S corporation status; however, if the second class of common stock also is limited to a smaller portion of the earnings and profits each year, this would constitute two classes of stock and S corporation status would be disallowed by the IRS.

Number of Owners

The IRS limits the number of shareholders in an S corporation to 100. Under this rule, a husband, wife and other family members would count as one shareholder. A family member is defined as a lineal descendant of a common ancestor not more than six generations removed from the youngest member of the family, and any spouse or former spouse of the common ancestor and the lineal descendants. For example, a husband and wife, their three children and their spouses, and their four grandchildren and spouses, would all be considered one shareholder as long as they agreed to be treated as one owner.

Owner Qualifications

Generally speaking, S corporation owners must be individuals, and they must be citizens or residents of the U.S. If even one shareholder is a nonresident alien, a corporation or a partnership, the company will not qualify for S-corporation status. Exceptions to this rule apply to estates, so if a shareholder dies, the S corporation will not be disqualified while the shares are held by the decedent's estate. In addition, certain trusts as well as 401(a), 501(c)(3) and 501(a) organizations are permitted to be shareholders in S corporations.