S Corporation Restrictions

By Mike Keenan

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.

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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.

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Subchapter S Corporation Stock Regulations


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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 that the company have only one class of stock. Violating this requirement for your S corp, even accidentally, can have severe tax consequences both for your business and your personal income tax return.

S Corporation Regulations

An eligible existing corporation can elect to become an S corporation. This means that the corporation is taxed under the provisions of Subchapter S of the U.S. Tax Code. The purpose of this election is to avoid double taxation. Thus, rather than taxing the corporation and then taxing the shareholders, all the corporate income passes through to the individual shareholders, who only have to report the income on their individual tax returns.

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.

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