Why Limit the Number of S Corporation Shareholders?

By Cindy DeRuyter, J.D.

Why Limit the Number of S Corporation Shareholders?

By Cindy DeRuyter, J.D.

Many small business owners choose to establish their new businesses as corporations and elect S corporation status. Doing so can provide potential tax benefits while still protecting the shareholders' personal assets from liability for the company's obligations.

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Because they are intended primarily for family-owned and other small businesses, S corporations are limited to no more than 100 investors (shareholders). When the number of shareholders in an S corporation exceeds the maximum allowed by law, the business must file and pay taxes as a C corporation.

S Corporation Defined

A corporation is a common type of business entity that offers investors liability protection, limiting their risk of loss to the extent of their investment in the company. Corporations are separate legal entities formed under state laws. By default, a corporation is treated as a C corporation and will be taxed at the corporate level before earnings are passed on to shareholders and taxed again as individual income.

After formation, eligible corporations can file Form 2553 with the IRS to be taxed as S corporations, avoiding double taxation. Corporations that qualify and elect S corporation status do not pay federal income taxes at the corporate level, subject to certain limited exceptions. Instead, profits and losses are passed through to the shareholders in the same manner as LLC, partnership, and sole proprietorship income.

Treatment of Related S Corporation Shareholders

S corporations must have 100 or fewer shareholders, but there are special rules that can allow multiple members of the same family to be treated as a single shareholder.

All members of a family and their estates, as defined in section 1361(c)(1)(B), can be counted as a single shareholder. That code provision defines "family" as an individual, his or her spouse, ancestors, lineal descendants, and any trust created for the primary benefit of one or more of those people.

Characteristics of S Corporations

In addition to the shareholder restrictions, S corporations are only allowed to issue one class of stock. In contrast, C corporations can issue both common and preferred stock, which may help attract private investors.

It is also important to note that only domestic U.S. companies can elect S corporation treatment; foreign corporations cannot do so.

While a corporation can be a shareholder or investor in another corporation or an LLC, S corporations may not have corporate shareholders. Generally, only individual U.S. residents can invest in an S corporation, although there are some exceptions for estates and certain trusts.

Historical Changes in the Maximum Number of S Corporation Shareholders

S corporations were designed for family-owned and other small businesses, to give those companies another choice of entity. Because of that, when the law creating S corporations was passed in 1958, this form of business entity could have a maximum of 10 shareholders.

In 1976, that limit was increased to allow up to 15 investors to have a stake in an S corporation. Over the years, that number was increased again to 35, then to 75 shareholders. In 2004, the current 100-shareholder limit was established.

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.

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