An S corp is simply a C corporation that makes a special election for tax purposes. Instead of having to pay the corporate tax, an S corporation passes its income and losses through straight to the shareholders. The election is made with IRS Form 2553. However, not all corporations qualify to be S corps.
Individual Shareholder Requirements
Only individuals that are either U.S. citizens or U.S. residents can be shareholders. Non-resident aliens and citizens of foreign countries who are not residents are not permitted to own stock in an S corp. For example, if the S corp needs cash and issues shares to a Canadian citizen who is not a U.S. resident, the S corp would violate shareholder requirements.
Entity Shareholder Requirements
Most entities, such as partnerships and corporations, are prohibited from being shareholders in S corporations. However, there are a few exceptions. The estates of deceased shareholders can hold the S corp stock. Nonprofit organizations under section 501(c)(3) and tax-exempt organizations under section 501(a) are also permitted to own stock. Although most trusts are excluded from ownership, certain types of trusts, such as qualified sub-chapter S trusts (QSSTs) and electing small business trusts (ESBTs), are permitted to own stock without disqualifying the S corp election.
Total Shareholder Limits
An S corporation is limited to no more than 100 shareholders. However, there are exceptions that permit family members to elect to be counted as just one shareholder, which can greatly increase the limit. Family members include the descendants of a common ancestor, no more than six generations above the youngest owner at the time of the elections. Spouses are also included. For example, if you, your spouse, your children, and your sister and her children own shares, you can elect to count all of you as just one shareholder.
Consequences of Violations
If a prohibited person or entity gains ownership of S corp stock, the S corp election is revoked immediately. For example, if you sell some of your stock to a non-resident alien, the S corp goes back to being a C corp on the date of the sale, even if it is in the middle of the tax year. After a violation, you usually can't elect to go back to an S corp for at least five years even if the violation is fixed before then.
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."