We all heard of S corporations and way to many business owners jumped into the S Corp structure without proper research just by basing their decisions on TikTok and Youtube videos.
However, not all business can be an S Corp. The IRS has certain requirements for businesses that want to convert to the S Corp stratus. If these requirements are not met, the business risks losing its S Corp status and be converted to a C Corp, which in many cases the least beneficial tax entity.
Here’s a detailed overview of the essential S Corp tax requirements, covering the shareholder limits, eligible shareholder types, stock structure, and other criteria that a business must adhere to in order to qualify and remain compliant as an S Corp.
1. Shareholder Limit
An S Corporation is restricted to a maximum of 100 shareholders. This rule is designed to ensure that the corporation remains small and closely held. Unlike larger C Corporations, which can have an unlimited number of shareholders, S Corps are meant to be simpler and more personal in nature. However, this 100-shareholder limit can be flexible in some circumstances.
- Counting Family Members as a Single Shareholder:
The IRS allows family members to elect to be treated as one shareholder. For instance, if you, your spouse, your children, and your parents each own shares in an S Corporation, rather than being counted as separate shareholders, you can elect to be treated as one. This rule allows families to hold more shares in an S Corp without breaching the 100-shareholder cap, which provides flexibility in family-run businesses. - Married Couples:
A married couple is automatically treated as a single shareholder for purposes of the 100-shareholder limit. This remains the case even if they hold their shares jointly or separately. However, in the event of a divorce, each former spouse will then be counted as a separate shareholder, which could affect the corporation's ability to stay within the 100-shareholder limit. - Shares Held by Agents or Custodians:
If an agent holds shares on behalf of an actual owner, it is the owner who is counted as the shareholder. This rule applies even when shares are held in custodial accounts for minors. For example, if a parent holds shares on behalf of a child in a custodial account, the child is considered the shareholder, not the parent or guardian managing the account. - Multiple S Corporations in a Partnership:
To navigate the 100-shareholder limit, S Corporations can form partnerships with other S Corps. This allows the businesses to work together and expand their ownership base without exceeding the limit. Essentially, the partnership holds the shares on behalf of the shareholders of each individual S Corp, enabling greater flexibility in ownership structures.
2. Eligible Shareholders
Not just anyone can be a shareholder in an S Corporation. To maintain its tax-advantaged status, S Corps must ensure that all shareholders fall into specific categories. If the corporation allows an ineligible person or entity to own shares, it will lose its S Corp status. Below are the types of shareholders that qualify for S Corp ownership:
- Individuals (U.S. Citizens or Residents):
Shareholders in an S Corporation must be U.S. citizens or residents. Non-resident aliens cannot be shareholders. If a U.S. citizen is married to a non-resident alien, the non-resident spouse cannot own shares in the S Corp, even if their spouse does. This rule is critical for S Corps to ensure compliance with IRS requirements. - Estates and Trusts:
Certain estates and trusts can hold shares in an S Corporation, but only for a limited time or under specific conditions. For example, an estate can hold shares temporarily after a shareholder’s death while the shares are being transferred to a qualifying individual or trust. There are specific types of trusts, such as grantor trusts, qualified subchapter S trusts (QSSTs), and electing small business trusts (ESBTs), that can hold shares. However, other types of trusts, like charitable remainder trusts and foreign trusts, are not eligible. - Charitable Organizations:
Charitable organizations can hold shares in an S Corporation, but they must meet certain requirements. Individuals can donate their shares to charities, allowing these organizations to benefit from the corporation’s profits. This can be a tax-efficient way to contribute to a charity while maintaining control of the corporation through other shareholders. - Bankruptcy Estates:
If a shareholder declares bankruptcy, their shares can be held by their bankruptcy estate. The estate can continue to hold the shares, but they must eventually be transferred to an eligible shareholder to ensure that the corporation remains compliant with the IRS rules. - Ineligible Shareholders:
Certain entities are explicitly prohibited from owning shares in an S Corp. These include partnerships, C corporations, non-resident aliens, and most types of IRAs. If an S Corp issues shares to an ineligible shareholder, it risks losing its S Corporation status.
3. Corporate Structure
In order to qualify for S Corp status, the business must be structured as a domestic corporation or an LLC on the state level. This means that the corporation must be incorporated within the United States, following the laws of one of the 50 states or the District of Columbia. The corporation must also have a physical business presence in the U.S.
- Domestic Corporation Requirement:
An S Corp must be a domestic corporation. The IRS requires that the company be established in the U.S. and that it operates primarily within U.S. borders. Foreign corporations, unless they go through a process known as "domestication," cannot qualify for S Corporation status. Domestication involves the re-incorporation of the foreign entity under U.S. laws. - Prohibited Business Structures:
Certain types of corporations are not allowed to elect S Corporation status. These include financial institutions using a reserve method for bad debts, insurance companies, and domestic international sales corporations (DISCs). These types of businesses cannot benefit from the tax structure offered to S Corporations because their operational models are incompatible with the S Corp's closely held, pass-through nature.
4. Stock Classes
One of the defining characteristics of an S Corporation is its stock structure. Unlike C Corporations, which can issue multiple classes of stock with varying rights and preferences, S Corps are limited to a single class of stock. This rule is designed to ensure that all shareholders have an equal stake in the corporation and its profits.
- Single Class of Stock:
An S Corp can only issue one class of stock. All shareholders must have the same financial rights, meaning they receive the same dividends and share equally in the company's assets upon liquidation. This uniformity in financial rights prevents S Corporations from issuing preferred stock or other forms of equity that might give certain shareholders preferential treatment. - Voting and Non-Voting Shares:
While an S Corp can only issue one class of stock in terms of financial rights, it can issue both voting and non-voting shares. Non-voting shares are useful for giving certain shareholders a stake in the company without granting them control over corporate decisions. For instance, non-voting shares can be issued to employees or family members who do not need decision-making power but still want to benefit financially from the company’s success. - Debt and Stock Classification:
A corporation’s debt must be carefully structured to avoid being classified as a second class of stock. To prevent this, the debt must be formalized in writing and must include a clear promise to repay a specific amount at a specific time. Additionally, the debt cannot be convertible into stock. If these conditions are not met, the IRS may treat the debt as a second class of stock, which would violate the S Corp rules and could result in the loss of S Corp status.
5. Other Tax Requirements
Even if a corporation meets all the structural and shareholder requirements, there are still other considerations to maintain its S Corp status. The company must consistently file Form 1120S with the IRS and issue K-1 forms to all shareholders, detailing their share of the income, deductions, and credits. Failure to file these forms on time or correctly can lead to penalties and could jeopardize the corporation’s S status.
- Reasonable Compensation:
S Corps must also ensure that they are paying reasonable compensation to shareholder-employees. The IRS requires that shareholder-employees who provide services to the S Corp receive a fair market salary. This rule is in place to prevent S Corps from avoiding payroll taxes by distributing profits solely as dividends, which are not subject to employment taxes.
Besides legal considerations, there is also the notion of cost analysis. Yes, S-Corps save on employment taxes and can be used for other tax planning projects (you can read more about this here). But they can also be costly. We've seen many S-Corps created without proper consideration, saving less than they were costing. Consider additional costs like a separate tax return, payroll filings, accounting software, and a minimum $800 franchise tax fee (if you're in California), which we discussed here. These expenses add up and, to be honest, sometimes aren't worth it.
At our firm we do cost analysis before we offer the S Corp structure to our clients. Our clients know how much they are savings and how much they will be spending before they jump into the S Corp structure. You can read more about our services here.