Requirements to Form an S Corporation

To establish an S corporation, the following criteria must be met:

1. Shareholder Limit:

• Maximum Number: To qualify as an S corporation, a business must have no more than 100 shareholders. This limit ensures that the corporation remains relatively small and closely held. To work around this restriction, multiple S corporations can form a partnership. This partnership can then collectively own shares in other S corporations. In this arrangement, the partnership itself is controlled by several S corporations, allowing the combined entity to effectively manage more than 100 shareholders indirectly.

  • Family Members: When an individual owns shares in an S corporation along with their parents or children, each family member who owns shares is counted individually as a separate shareholder. This means that if you, your parents, and your children each own shares, each person is treated as a distinct shareholder. To manage the total number of shareholders and stay within the 100-shareholder limit, family members can choose to be treated as a single shareholder. This option allows all the shares held by the family to be considered as owned by one shareholder for the purpose of this limit.
  • Married Couples: A married couple holding shares together counts as one shareholder. If a divorce happens, each spouse is considered a separate shareholder.
  • Shares Held by Agents: If an agent (such as a broker or representative) holds shares in an S corporation on behalf of a principal (the actual owner), the principal is recognized as the shareholder. This means the principal, not the agent, has the rights and responsibilities associated with the shares. Similarly, when a custodian (such as a parent or guardian) holds shares on behalf of a minor (someone under the legal age), the minor is considered the shareholder. Even though the custodian manages the shares, the minor is the one who holds the ownership interest and associated rights.

2. Eligible Shareholders

• Permissible Types: Shareholders must be individuals, decedent's estates, or certain types of trusts. If this condition is not met, the S corporation must dissolve. Below is the list of various tax entities that are can and can not own share of an S Corp.

  • Bankruptcy: Shareholders who have declared bankruptcy and bankruptcy estates can hold shares.
  • C Corporations: A C corporation cannot be a shareholder in an S corporation, but an S corporation can own shares in a C corporation.
  • Charitable Organizations: These entities can be shareholders, allowing individuals to donate shares to charities.
  • Employee Benefit Trusts: Trusts like employee stock ownership plans can hold shares and are counted as one shareholder.
  • Estates: An estate can hold shares temporarily until they can be transferred to an eligible shareholder.
  • IRAs: Individual retirement accounts cannot be shareholders.
  • Resident Aliens: Non-resident aliens cannot hold shares, but resident aliens can. A non-resident alien spouse of a U.S. shareholder cannot own shares.
  • Partnerships: Partnerships cannot be shareholders. This means that an S Corps cannot issue a K-1 to a partnership. However, an S corporation can own a partnership. The S corporation receives a K-1 form from the partnership. In its turn, the S corporation reports this information on its own tax return (Form 1120S) and passes the relevant income, deductions, and credits through to its shareholders via their K-1 forms.
  • Trusts: Only specific types of trusts (grantor, Section 678, testamentary, voting, electing small business, or qualified subchapter S trusts) can hold shares. Foreign, charitable remainder, and charitable lead trusts cannot.

3. Corporation Type:

• Domestic Corporation: For an entity to qualify as an S corporation, it must be a domestic corporation. This means it needs to be incorporated under the laws of a U.S. state. Essentially, the corporation must have its primary place of business and legal incorporation in the United States. However, a foreign corporation can become a domestic corporation by going through a process called "domestication".

4. Stock Classes:

• Single Class: An S corporation must have only one class of stock. This means it cannot issue different types of stock with varying rights or preferences, such as preferred stock or different classes of common stock with distinct economic benefits.

  • Voting Shares: An S corporation can issue both voting and nonvoting common stock. Both voting and nonvoting shares must have identical economic rights to the corporation’s assets and income. This means that all shares should receive the same dividends and have the same rights to the company's profits and in case of liquidation. Nonvoting shares in an S corporation can help in several ways: they can allow income to be shifted to children without granting them voting rights, non voting shares can help attract investment while preserving existing voting power, and they can also provide compensation to employees without impacting overall control of the corporation.
  • Debt: Debt is not considered a second class of stock if it follows specific guidelines: it must be in writing, include an unconditional promise to pay a set amount on a specific date, have a specific interest rate, and not be convertible into stock.
  • Restricted Stock: An S corporation can give its employees restricted stock as part of their compensation. This usually happens when employees meet specific goals or after a certain period of time. The shares are not fully considered as "owned" (or "outstanding") by the employees until they meet the required conditions, such as staying with the company for a certain number of years or achieving specific performance goals.

Even if an entity meets all these requirements, it cannot obtain S corporation status if it is structured as:

• A corporation electing the Puerto Rico possession tax credit
• A domestic international sales corporation
• A financial institution using a reserve method for bad debts
• An insurance company subject to tax

These rules ensure that an S corporation operates within the specified legal and financial framework.