S Corporation Compliance

By Mike Keenan

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

References

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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 Corporation Restrictions

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.

Subchapter S Corp Restrictions

Most people decide to incorporate their small businesses for the protection it gives them from personal liability for most business debts and obligations. The protection offered by operating a business as a corporation comes at a price. Corporate income is subject to double taxation: once when the corporation pays income taxes, and the second time when the shareholders pay income taxes on dividends they receive. Corporations that meet the restrictions for Subchapter S status can avoid double taxation. Income and losses of a Subchapter S or, as it is more commonly called, an S corporation, are passed through the corporation to the shareholders to be reported on their personal income tax returns, and the shareholders pay individual income tax rates that are lower than corporate rates.

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