S Corp. Shareholder Requirements

By Ari Mushell, J.D.

S Corp. Shareholder Requirements

By Ari Mushell, J.D.

If you're considering starting an S corporation, it might be because you plan to raise capital by selling shares to investors. Raising capital in this manner is an option that's unavailable to some other types of business entities, and it can be more advantageous than trying to procure a loan. However, only certain individuals or entities can be S corporation shareholders, and selling a share to an ineligible party can cause your business to lose its favorable S corporation status.

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S Corporation Benefits

Existing as an S corporation can be beneficial because they afford owners limited liability and special tax benefits. Like C corporations, they have shareholders who each hold a stake in the company's equity. However, C corporations experience double taxation on their profits, while S corporations are pass-through entities. They pass income through to their shareholders, who pay taxes on it with their individual income tax returns.

In contrast to C corporations, S corporations have a limited marketplace for trading shares. C corporations trade shares on the open market on large platforms that have international reach, and selling shares in this manner can raise large amounts of capital. S corporations, on the other hand, cannot sell shares on the open market.

Ineligible S Corporation Shareholders

The following individuals or entities cannot hold shares of an S corporation:

  • Partnerships
  • Corporations
  • Financial institutions
  • Insurance companies
  • Non-resident aliens
  • Citizens of foreign countries
  • Multi-member LLCs

These restrictions significantly limit the population of eligible shareholders. There are, however, exceptions. For example, the estate of a deceased shareholder can continue to be a shareholder of the S corporation. Similarly, the bankruptcy estate of a shareholder who filed a bankruptcy petition can also continue holding shares in an S corporation.

Shareholder Cap

S corporations have a shareholder cap of 100. If someone purchases shares in an S corporation and pushes the number of shareholders over 100, the sale is illegal—even if the individual is otherwise eligible to buy them. Exceeding the shareholder cap can cause the corporation to lose its S status. Further, you might have to wait a number of years before applying for S status again.

The 100-shareholder rule does have some interesting characteristics. For example, a husband and wife who hold shares in an S corporation are considered to be one shareholder—as are the estates of a husband and wife—and a family member can elect for all family members to be considered a single shareholder.

Sale to an Ineligible Shareholder

If an ineligible shareholder purchases shares of your S corporation, the IRS can strip your corporation of its S status and tax it as a C corporation. Consequently, your corporation would be subject to taxation at both the corporate and personal levels. There could be other financial penalties associated with the sale too.

Starting an S corporation can be very exciting. However, if you plan on selling shares of your corporation, be mindful that there is a limited pool of potential investors. If you want to keep your S corporation status, you must be careful when selling corporate shares.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.