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.
Read More: How Is Passive Income Taxable to an S Corporation Shareholder?
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.
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.
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.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."