S Corporation Restrictions

By Mark Kennan

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.

Passive Income Limits

S corporations generally cannot have more than 25 percent of their income be generated by passive activities; otherwise, it is subject to an extra tax on those earnings. Passive activities are those in which you don't materially participate "on a regular, continuous, and substantial basis." For example, if the S corp had rental properties or derived profits from interest income, those would count as passive activities. If an S corp has more than 25 percent of its income from passive activities for three years in a row, the IRS strips the S corp of its special status and taxes it as a C corp.

Size of Ownership

An S corp cannot have more than 100 shareholders without reverting back to a C corp. The only way to manipulate this limit is that family members can be counted as one shareholder. For example, if your parents also own stock in the S corp, you and your parents could choose to be counted as just one shareholder. To prevent running afoul of these restrictions, consider using shareholder agreements that restrict to whom current shareholders can sell their stock, or require that existing shareholders have a first right to buy the stock.

Ready to incorporate your business? Get Started Now

Individual Ownership

With few exceptions, only individuals who are U.S. citizens or residents can own S corp stock. The presence of just one non-qualified owner in the S corp will cause it to lose its special status and revert to a C corp. One exception is made for the estate of a decedent owner. For example, if you owned stock and then died, the presence of S corp stock would not immediately invalidate the S corp election. Also, nonprofits and a few types of trusts are also permitted as owners.

Stock Characteristics

All shares of stock issued by the S corp must be identical in every characteristic except voting power. For example, if certain shares receive extra payouts or have priority to receive their money back if the S corp dissolves, these shares would constitute a second class of stock, which is prohibited for S corps. Alternatively, if some of the shares had voting rights and others had no voting rights, the S corp would not lose is special status, so long as that was the only difference.

Ready to incorporate your business? Get Started Now
Subchapter S Corporation Stock Regulations


Related articles

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.

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.

S Corporation Operational Limitations

An S Corporation is a type of business that is registered with the IRS for a special tax status. This classification allows a business' shareholders to include a portion of the S-Corp’s income on their personal tax return, as determined by the amount of shares they own in the business. This tends to minimize the overall amount of taxes paid on business income. In exchange for this right, the S-Corp must comply with several restrictions. Some of these can influence how the business operates and its flexibility.

LLCs, Corporations, Patents, Attorney Help Incorporation

Related articles

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 ...

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 ...

S Corp Vs. Corp

Incorporating a business creates a separate legal entity and protects shareholders with limited liability. However, a ...

Tax Consequences of Converting a C-Corp to an S-Corp

Corporations are business entities formed under state law that exist separately from their owners. An S corporation is ...

Browse by category
Ready to Begin? GET STARTED