S Corporation Compliance

By Mark Kennan

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.

Ineligible Shareholders

Not everyone can be a shareholder in an S corporation. If any of the shares in the S corporation are held by an ineligible shareholder, the S corp reverts to a shareholder. Individuals must be either U.S. citizens or U.S. residents. The only entities permitted to own S corp stock are estates of deceased shareholders, certain trusts and certain nonprofit organizations. To assure compliance with the rules, most S corps have shareholder agreements limiting whom shareholders can sell their shares to.

Limited Shareholders

S corps must comply with the 100 shareholder limit. If at any time an S corp has more than 100 shareholders, it reverts to a C corp. This limit isn't a hard cap because family members can elect to be considered just one shareholder. Shareholders include descendants of a common ancestor no more than six generations back as well as the descendants' spouses. Adopted children are treated the same as biological children.

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Stock Types

S corps are prohibited from having more than one class of stock. Examples of different classes of stock include shares with different priority for receiving payouts or different dividend amounts. However, for the purposes of S corp compliance, stocks can have different voting rights without being a second class of stock. For example, if one share has voting rights and another does not, the S corp is still in compliance.

S Corps with Earnings and Profits

If the S corporation was formerly a C corp and has earnings and profits carried over, the S corporation cannot have more than 25 percent of its gross receipts from passive income for more than three years in a row. Passive income includes rentals, stock investments or interest income. If this happens, the S corp reverts to being taxed as a C corp on the first day of the first taxable year starting after the third year.

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Subchapter S Corporation Stock Regulations


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S Corporation Passive Income Restrictions

An S corporation is a corporation consisting of 100 or fewer shareholders that has a special tax designation granted by the IRS. While this designation offers the shareholders certain tax benefits, it requires the company to adhere to several restrictions and conditions. One of these restrictions involves how much passive income the business earns. It is important for an S corporation to closely monitor how much passive income it earns to ensure that it avoids any IRS penalties or tax repercussions.

S-Corp Shareholder Requirements

An S corporation is a business that has made the election to be taxed as a pass-through entity, meaning that each shareholder reports her portion of the business's income on her personal tax return. However, noncompliance with the shareholder limitations could terminate the S corporation election, causing the company to be taxed as it was before the election. For example, if the company was a C corporation before the election, it goes back to being taxed as a C corporation. Instead of the company’s income being taxed just once, it’s hit with the corporate tax when the company makes the money and with the personal income tax when the company distributes it to shareholders.

Can an S Corp Issue Stock?

An S corporation may issue stock to its owners. However, the Internal Revenue Service imposes a significant number of restrictions on the stock issued by the S corp, which may make an S corp an ineffective business entity for certain entrepreneurs. Knowing the restrictions before you decide the entity type you want to use for your business helps you make a better decision.

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