S Corps offer a bevy of tax benefits to small business owners. In particular, they let you reduce the payroll taxes you owe by taking your company’s profits as distributions.
If you’re a Business-of-One, ownership in your S Corp is relatively simple because you own the company entirely. However, if you have business partners, you’ll need to figure out the allocation of ownership if you are considering this type of tax status. Whether you’re in business alone or with others, here’s what you need to know about the rules and restrictions regarding ownership of S Corps.
Advantages and Disadvantages of S Corp Ownership
For small business owners going through the incorporation process for a limited liability company (LLC) business structure, there are many advantages to electing S Corp taxation instead of being taxed as a sole proprietorship.
S Corps, also known as Subchapter S Corporations, are pass-through entities. This means the company can pass on business profits and losses to shareholders to report on their personal tax returns. The company doesn’t pay corporate income tax on any business income. Employees and shareholders pay federal income taxes at their own unique tax rates.
This pass-through taxation also ensures there is no double taxation on the money you earn as a business owner, which is something C Corps face on their taxable income. S Corp owners must pay themselves a “reasonable compensation” via payroll. In other words, S Corp owners receive a salary from their business.
However, S Corps have some disadvantages. One downside is that you must file form 1120s for your business and complete a personal income tax return. Also, S Corp election is only applicable for federal tax purposes, meaning you might be taxed differently on the state level.
S Corp ownership eligibility
The Internal Revenue Service (IRS) has a relatively short list of requirements that a business must meet for S Corporation election. According to IRS.gov, requirements include:
- Being a domestic corporation
- Having only allowable shareholders
- Can be individuals, certain trusts and estates and
- Can’t be partnerships, corporations or non-resident alien shareholders
- Having no more than 100 shareholders
- Having only one class of stock
- Not being an ineligible corporation (such as insurance companies or financial institutions)
This means certain restrictions exist about who can have an ownership share in an S Corp. For example, if there are already 100 people who own shares, you can’t sell shares to a non-shareholder because that would push you above the 100-shareholder limit.
However, the IRS classifies family members as single shareholders for these purposes. So, if you and your brother each own shares, you count as a single shareholder and can sell shares to up to 99 other people.
Residency requirements
IRS rules restrict ownership in an S Corp to “allowable shareholders” and specifically prohibit non-resident aliens from owning shares. The good news is that if you’re a U.S. citizen, you can own shares in an S Corp regardless of where you live. Whether you reside in the United States or live abroad, your citizenship qualifies you to own a stake in an S Corp.
If you’re not a citizen, you must qualify as a resident alien to own a stake in an S Corp. Resident aliens are those who have moved to the United States and have residency but aren’t citizens. Of the below, only permanent residents can own an S Corp.
The United States Citizenship and Immigration Services lists three categories of resident aliens:
- Permanent residents: Those with the legal right to live in the U.S. permanently. This is also known as having a Green Card.
- Conditional residents: These people are approved to live in the United States for at least two years. Typically, this status is for people who are applying for permanent residency. If they fail to secure a Green Card, conditional residents may need to leave the United States.
- Returning residents: Residents who leave the United States for an extended period may need to reapply to return to the U.S. Those who do become returning residents.
Classes and types of stocks
Another rule for S Corp ownership is that your business can only have one class of stock. Generally, this isn’t a big deal. It means that every share in your company is the same and confers the same ownership rights and benefits. However, it can be a downside if you want different classes of S Corporation stock to control voting rights.
Sometimes, larger companies have multiple classes of stock. For example, Alphabet, the parent company of Google, has two major classes of stock. These include Class A stock, trading under the ticker symbol GOOGL, and Class C stock, trading under the ticker symbol GOOG.
In 2014, the company issued a share of Class C stock for every share of Class A stock its shareholders owned. This means that if you owned 100 shares of GOOGL, you then owned 100 shares of GOOG and 100 shares of GOOGL.
The critical difference between these shares is voting rights. Class A shares give the holder voting rights when it comes time to make decisions for the company. Class C shares still give the holder ownership in the company but don’t offer voting rights. Alphabet also has Class B shares, held primarily by company insiders, which offer 10 votes per share.
The restriction that S Corps can only have one class of shares means that you can’t structure your S Corp to give people ownership without a say in how the company operates. For many S Corps, that’s unlikely to be a significant problem, but it’s still worth noting this potential downside.
Pros and cons of having trusts or estates own shares
Under IRS filing requirement rules, some trusts, estates and exempt organizations can own shares in an S Corp. Rules surrounding what trusts are permitted to own shares in an S Corp can be complex. In some cases, ownership can be fine at first, but as the purpose or activities of the trust change, it may stop being a qualified shareholder.
For example, if someone establishes a living trust, it typically starts as a grantor trust. Grantor trusts are valid shareholders for an S Corp. However, once the grantor becomes incapacitated or dies, the trust is no longer revocable, meaning it loses its grantor trust status. This could impact whether it’s a qualified shareholder.
Using a trust or estate for S Corp ownership can offer various tax benefits and legal perks. That said, this type of business entity can get complex enough that you should work with a legal pro to understand the nuances of your specific situation.
Avoiding potential pitfalls
S Corp ownership rules aren’t complicated to follow. They generally only become complex once you add additional shareholders or use trusts as shareholders.
The easiest way to avoid pitfalls is to keep things simple. If you’re the only shareholder, you must ensure you’re a U.S. citizen or permanent resident to ensure your S Corp doesn’t break ownership rules.
Adding another owner or two also won’t make things very complicated. You can all be treated as a single shareholder if they’re your family members.
But, if you want to add multiple other S corporation shareholders, you must do your due diligence to understand the applicable tax laws and internal revenue codes. Before selling shares to anyone, make sure they plan to own the shares directly rather than place them in a trust. Also, take the time to confirm that they’re a legal resident or citizen.
Remember that because you can only have one class of share, each share you sell dilutes your ownership and control over the company. That should offer some incentive to limit the number of shareholders you add.
Can you own an S Corp?
To figure out whether you can elect S Corporation status, ask yourself these questions:
- Am I a U.S. Citizen or permanent resident?
- Will I own the S Corp directly or through a single-member LLC, qualified trust or estate?
- Will there be fewer than 100 other shareholders in the S Corp?
- Does the S Corp have only one class of stock?
If you answered yes to all of these questions, you should be able to own shares in an S Corp. If you answered no to any of them, there are problems that will prevent your ownership. It’s worth consulting a legal professional before buying shares in an S Corp or forming one to ensure you don’t violate these rules.
Final word
S Corp ownership rules can sound complex, but they are relatively easy for most people to follow. If you’re going into business alone or with just one or two partners, figuring out how to follow the rules should be simple.
Adding lots of shareholders is where things get complicated. Before adding any shareholders to your S Corp, make sure you fully understand the ownership rules.
