While all corporations are created equal, they do not always remain equal in the eyes of the IRS. Every corporation begins its life as a C Corporation, but owners can then elect to be treated as an S Corporation by filing Form 2553. Although the S Corporation status can be advantageous in some situations (i.e. avoiding double taxation), there are guidelines that the shareholders need to follow in order to maintain this status. If these rules are not followed the S Corp status can be revoked and your corporation will be subject to regular corporate tax and your shareholders will be subject to income tax on their distributions.
Some people may think that the last step in becoming an S Corp is filing the proper forms with the IRS, but the reality is the S Corp status requires more attention than some other entity types. The guidelines to maintain your S Corp status are not hard, but if you are unaware of these rules it can be easy to inadvertently terminate your S election. If you have an S Corp or are thinking about electing into an S Corp then make sure you are aware of the following rules.
S Corporations cannot have “Nonresident” shareholders. This doesn’t mean that foreign shareholders are not allowed, it just means that the shareholder needs to be a resident alien or a citizen of the United States. If your shareholders meet that criteria your S Corp status will not be terminated.
Only certain types of shareholders are permitted. Individuals, estates and certain trusts or exempt organizations are allowed to become shareholders of an S Corporation. Other business entities such as partnerships, LLCs and other corporations cannot be shareholders in an S Corp. There are a number of trusts that are capable of being shareholders, especially for estate planning purposes, but before adding the trust as a shareholder it is best to consult your tax professional for the proper guidance.
Your S Corporation cannot have more than 100 shareholders. This rule seems very straightforward, but there are some things to keep in mind such as the family aggregation rule. This means that all members of a family are treated as one shareholder, which can cause the “actual” number of shareholder to be in excess of 100. The only requirement to the family shareholder rules is that the common ancestor cannot be more than six generations removed from the youngest shareholder. With that being said, the family shareholder rules can be extremely advantageous for wealth transfer and estate planning.
Only ONE class of stock is allowed to be issued. This is perhaps the most common and most limiting requirement that S Corporations must adhere to, and it can be quite confusing. The most basic understanding of this rule is that the corporation’s stock must have identical rights to distribution and liquidation proceeds. Although this sounds straightforward, like most tax laws, it is not. Unfortunately, there are common every-day actions that can be treated as an impermissible “second” class of stock. Some examples are disproportionate distributions, certain loan agreements, and some employment agreements.
The information above is provided to emphasize the importance of awareness when electing the S Corporation status. Please contact your L&B professional at 858-558-9200 to discuss how this affects you.