Subchapter S Corporation Stock Regulations

By Michael Keenan

S corporations are ideal for companies with few owners who would rather report the income on their own tax returns rather than have the company pay the corporate tax. However, S corporations s have strict regulations on the stock issued by the company. Just one violation can trigger a reversion to a C corporation, thereby nullifying the tax benefits granted to an S corp.

S corporations are ideal for companies with few owners who would rather report the income on their own tax returns rather than have the company pay the corporate tax. However, S corporations s have strict regulations on the stock issued by the company. Just one violation can trigger a reversion to a C corporation, thereby nullifying the tax benefits granted to an S corp.

Permissible Owners

Only individuals who are U.S. citizens or U.S. residents can own S corporation stock. If you aren't a U.S. citizen or resident, you can't own any. Corporations, partnerships and most trusts are also excluded from ownership in S corporations. Estates, nonprofits and a few types of trusts – including grantor trusts, electing small business trusts, and qualified Subchapter S trusts – are permitted to own stock in the company without jeopardizing its status as an S corp.

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Number of Owners

Unlike C corporations, which can have thousands or even millions of owners, S corporations cannot have more than 100 owners. Originally, S corporations were limited to just 35 owners but that limit rose to 75 and eventually to 100 shareholders as of 2012. Generally, each person or entity that owns one share or more is counted as one shareholder. However, family members can elect to be treated as one shareholder for meeting the 100-shareholder limit.

Types of Stock

S corporations can issue only one class of stock. The only permissible difference between one share of stock and another is the voting rights. This could mean that certain shares receive extra voting rights, such as five votes per share for certain shares, or that some stock doesn't have any voting rights. However, if the shares have any other differences, the company is deemed to be in violation of the one-class restriction.

Consequences of Violations

Violating any of the S corporation stock regulations nullifies the S corporation election. When this occurs, the company reverts to being a C corporation for income tax purposes, meaning that the income no longer gets reported on the shareholders' individual tax returns. Instead, the company must pay the corporate tax, and then distributions to shareholders are taxed as dividends. For example, if the company grants rights to certain shareholders to get their money out ahead of the other shareholders, also known as a liquidation preference, the company has created a second class of stock. As a result, it loses its S corporation status and becomes a C corporation.

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S Corporation Restrictions

References

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Advantages & Disadvantages of a C-Corp or S-Corp

The U.S. Tax Code and IRS recognize two different types of corporations: the C corporation and the S corporation. The two business types are taxed in two different ways. The C corporation pays taxes on its annual income and then its shareholders pay tax on any dividends they receive from the business. With an S corporation, the business does not pay any tax on its annual income. The shareholders are responsible for paying taxes on their share of the business’s annual income. As a result of this difference in how these organizations are taxed, C corporations and S corporations have different restrictions on several aspects of their business.

Can an S Corp Have Two Classes of Stock?

An S corp cannot have two classes of stock. The IRS sets a number of requirements for S corporations, one of which is that the company have only one class of stock. Violating this requirement for your S corp, even accidentally, can have severe tax consequences both for your business and your personal income tax return.

S Corporation Compliance

Corporations that meet the qualifications to be an S corp can be taxed as a pass-through entity. This allows the shareholders to report the income on their personal returns, thus avoiding the corporate income tax. However, if the company doesn't comply with the S corp requirements, it will lose its special tax status and revert to being taxed as a C corporation.

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