S Corporation Restrictions

By Michael Keenan

An S corporation offers companies the ability to funnel their earnings and losses directly to the owners, thereby avoid double taxation. In addition, the use of the corporate structure grants the shareholders limited liability. However, the S corp election is very fragile. Making a mistake on just one of the restrictions can cause the company to lose its special status and therefore be taxed as a regular corporation.

An S corporation offers companies the ability to funnel their earnings and losses directly to the owners, thereby avoid double taxation. In addition, the use of the corporate structure grants the shareholders limited liability. However, the S corp election is very fragile. Making a mistake on just one of the restrictions can cause the company to lose its special status and therefore be taxed as a regular corporation.

Passive Income Limits

S corporations generally cannot have more than 25 percent of their income be generated by passive activities; otherwise, it is subject to an extra tax on those earnings. Passive activities are those in which you don't materially participate "on a regular, continuous, and substantial basis." For example, if the S corp had rental properties or derived profits from interest income, those would count as passive activities. If an S corp has more than 25 percent of its income from passive activities for three years in a row, the IRS strips the S corp of its special status and taxes it as a C corp.

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Size of Ownership

An S corp cannot have more than 100 shareholders without reverting back to a C corp. The only way to manipulate this limit is that family members can be counted as one shareholder. For example, if your parents also own stock in the S corp, you and your parents could choose to be counted as just one shareholder. To prevent running afoul of these restrictions, consider using shareholder agreements that restrict to whom current shareholders can sell their stock, or require that existing shareholders have a first right to buy the stock.

Individual Ownership

With few exceptions, only individuals who are U.S. citizens or residents can own S corp stock. The presence of just one non-qualified owner in the S corp will cause it to lose its special status and revert to a C corp. One exception is made for the estate of a decedent owner. For example, if you owned stock and then died, the presence of S corp stock would not immediately invalidate the S corp election. Also, nonprofits and a few types of trusts are also permitted as owners.

Stock Characteristics

All shares of stock issued by the S corp must be identical in every characteristic except voting power. For example, if certain shares receive extra payouts or have priority to receive their money back if the S corp dissolves, these shares would constitute a second class of stock, which is prohibited for S corps. Alternatively, if some of the shares had voting rights and others had no voting rights, the S corp would not lose is special status, so long as that was the only difference.

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Subchapter S Corporation Stock Regulations

References

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S Corp Vs. Corp

Incorporating a business creates a separate legal entity and protects shareholders with limited liability. However, a corporation can be either a C corporation or an S corporation. An S-corp is a C-corp that has made a special election. The differences relate to who can be a shareholder and how the company and shareholders pay taxes on the business's profits and losses.

Define S Corp

An S corp is not a separate type of corporation. Instead, it is merely an election that a corporation makes that changes its tax treatment under the Internal Revenue Code, Subchapter S. However, not all corporations are eligible to elect S corporation status. Knowing your options for your company can help you save money on your taxes so you can have more money to reinvest in your company.

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An S Corporation is a type of business that is registered with the IRS for a special tax status. This classification allows a business' shareholders to include a portion of the S-Corp’s income on their personal tax return, as determined by the amount of shares they own in the business. This tends to minimize the overall amount of taxes paid on business income. In exchange for this right, the S-Corp must comply with several restrictions. Some of these can influence how the business operates and its flexibility.

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