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.
Number of Shareholders
S corporations are limited to just 100 shareholders for the entire company. However, the IRS makes an exception that allows family members to count as just one shareholder. Family members include, for example, spouses and children. The rules on who also counts as a family member are complex, so it's wise to review them when the S corporation election is made.
Read More: How to Change the Shareholders' Percentage in an S-Corporation
Individual Shareholder Requirements
Only people who are either U.S. citizens or U.S. permanent residents are permitted to own S corporation stock. Nonresident aliens are specifically prohibited from owning stock in the S corporation. For example, if an S corporation has 50 shareholders, all U.S. citizens, and one sells his shares to a British subject living in England, the company loses its S corporation status.
The tax code further limits what types of non-individuals are permitted to own S corporation stock. Partnerships and corporations are forbidden from owning S corporation stock. However, the estate of someone who owned stock may continue to own the shares, as may the estate of an individual in bankruptcy. Also, certain types of trusts are also permissible owners. But, some types of institutions, including certain financial institutions and insurance companies, cannot be shareholders no matter how the business is organized.
One Class of Stock
S corporations are also limited to having just one class of stock. That means that an S corporation can’t have shares with different liquidation preferences or dividend rights. For example, one shareholder couldn’t be entitled to be paid a larger portion of the company’s profits than another shareholder with the same number of shares. However, the IRS does make one exception: shares can differ with regard to voting rights without being counted as separate classes of stock. For example, if some shares have voting rights but others don’t, that’s still one class of stock as long as there are no other differences.
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."