Subchapter S Corporation Stock Regulations

By Mike Keenan

S corporations are ideal for companies with few owners who would rather report the income on their own tax returns rather than have the company pay the corporate tax. However, S corporations s have strict regulations on the stock issued by the company. Just one violation can trigger a reversion to a C corporation, thereby nullifying the tax benefits granted to an S corp.

S corporations are ideal for companies with few owners who would rather report the income on their own tax returns rather than have the company pay the corporate tax. However, S corporations s have strict regulations on the stock issued by the company. Just one violation can trigger a reversion to a C corporation, thereby nullifying the tax benefits granted to an S corp.

Permissible Owners

Only individuals who are U.S. citizens or U.S. residents can own S corporation stock. If you aren't a U.S. citizen or resident, you can't own any. Corporations, partnerships and most trusts are also excluded from ownership in S corporations. Estates, nonprofits and a few types of trusts – including grantor trusts, electing small business trusts, and qualified Subchapter S trusts – are permitted to own stock in the company without jeopardizing its status as an S corp.

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Number of Owners

Unlike C corporations, which can have thousands or even millions of owners, S corporations cannot have more than 100 owners. Originally, S corporations were limited to just 35 owners but that limit rose to 75 and eventually to 100 shareholders as of 2012. Generally, each person or entity that owns one share or more is counted as one shareholder. However, family members can elect to be treated as one shareholder for meeting the 100-shareholder limit.

Types of Stock

S corporations can issue only one class of stock. The only permissible difference between one share of stock and another is the voting rights. This could mean that certain shares receive extra voting rights, such as five votes per share for certain shares, or that some stock doesn't have any voting rights. However, if the shares have any other differences, the company is deemed to be in violation of the one-class restriction.

Consequences of Violations

Violating any of the S corporation stock regulations nullifies the S corporation election. When this occurs, the company reverts to being a C corporation for income tax purposes, meaning that the income no longer gets reported on the shareholders' individual tax returns. Instead, the company must pay the corporate tax, and then distributions to shareholders are taxed as dividends. For example, if the company grants rights to certain shareholders to get their money out ahead of the other shareholders, also known as a liquidation preference, the company has created a second class of stock. As a result, it loses its S corporation status and becomes a C corporation.

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S Corp Vs. Corp

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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.

Can an S-Corp Own an LLC?

An S corp may own up to 100 percent of an LLC, or limited liability company. While all but single-member LLCs cannot be shareholders in S corporations, the reverse -- an S corporation owning an LLC -- is legal. The similarity of tax treatment for S corps and LLCs eliminates most of the common concerns about IRS issues. Both structures "pass through" profits and losses to their owners for personal income tax submission.

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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