S Corporation Eligibility Requirements
S corporations can be useful tools for saving self-employment taxes and avoiding double taxation. Both LLCs and corporations may elect to be taxed as S corporations, as long as they meet strict eligibility requirements:
- Domestic corporation. The business must be organized as a corporation or an LLC.
- Eligible shareholders. All shareholders must be eligible shareholders, defined to include individuals (other than nonresident aliens), estates, certain trusts, certain qualified retirement trusts, or charitable organizations.1
- Small business. The corporation cannot have more than 100 shareholders (with certain family groups counted as a single shareholder).2
- One class of stock. The corporation may only have one class of stock. Differences in voting rights are allowed, but all stock must have the same economic rights.3
Each requirement is discussed in more detail below.
To qualify as an S corporation, the business must be organized as a domestic corporation or as an LLC taxed as a domestic corporation.4 The business cannot be an insurance company, I.R.C. § 936 corporation, a DISC or former DISC, and certain types of financial institutions.5
The eligibility rules for S corporation shareholders are notoriously restrictive.6 For a business to elect to be taxed as an S corporation, each shareholder must be one of the following types of owners:
- Individuals. As long as they are not nonresident aliens, individuals are eligible S corporation shareholders. Individual may also co-own stock in an S corporation with other individuals.
- Bankruptcy estates. If an individual owner declares bankruptcy, the bankruptcy estate is a permissible shareholder.7
- Decedent’s estates. If an individual shareholder dies, his or her estate is an eligible S corporation shareholder.8
- Tax-exempt organizations. Tax-exempt organizations and retirement plans are eligible S corporation shareholders.9
- Testamentary trusts. A trust that becomes effective on the death of a shareholder (testamentary trust) may own S corporation stock for up to two years.10
- Voting trusts. Voting trusts are permissible S corporation shareholders.11
- Grantor trusts (including living trusts). Individuals are also permitted to hold their S corporation stock through grantor trusts during their life.12 Because living trusts and also grantor trusts, individuals may transfer S corporation stock to their living trust. Once the grantor dies, though, the grantor trust will only qualify as an S corporation shareholder for two years from the grantor’s death.13 To prevent disqualification, most well-drafted trusts hold S corporation stock in either a qualified subchapter S trust or an electing small business trust after the death of the shareholder.14
- Qualified Subchapter S trust (QSST). A QSST is an eligible S corporation shareholder if it meets strict eligibility requirements.15 A QSST must distribute all income to a beneficiary who is a U.S. citizen. During the life of the beneficiary, the beneficiary must be the only income beneficiary of the trust. Although the trust need not distribute principal to the beneficiary, the trust cannot distribute principal to any other beneficiary during the beneficiary’s life. On termination of the QSST, all QSST principal and income must be distributed to the beneficiary.
- Disregarded entities. An entity that is disregarded for tax purposes as separate from its owner—for example, a single-member LLC—may own stock in an S corporation if the owner is an eligible shareholder.16
- Electing small business trust (ESBT). An ESBT is a trust for beneficiaries that are all eligible S corporation shareholders that acquired their interest in the trust by lifetime gifts or upon the death of an owner. ESBTs have more flexible requirements that QSSTs, but income retained by an ESBT is taxed at higher rates.17
If the corporation has ineligible shareholders, it does not qualify as an S corporation.18 These restrictions present two common practical limitations:
- Partnerships and corporations. Partnerships and corporations are not eligible S corporation shareholders. Although there is an exception for qualified Subchapter S subsidiaries (discussed below), this restriction prevents many common business arrangements, including the holding company structure.
- Nonresident aliens. Nonresident aliens may not own stock in an S corporation.19 If an eligible shareholder is married to a nonresident alien and the nonresident alien has a community property interest in the stock under state law, that community property interest is treated as ownership by a nonresident alien and will disqualify the corporation from electing to be taxed as an S corporation.20
There is one exception to the prohibition of corporate shareholders. If an S corporation is owned by another S corporation, the subsidiary corporation may elect to be disregarded for tax purposes as a qualified subchapter S subsidiary.21 A qualified subchapter S subsidiary—or Q-Sub—is not taxed as a separate entity. The Internal Revenue Code treats the parent corporation as owning all of the assets, liabilities, and items of income, deduction, and credit of the Q-Sub.22 This allows a Q-Sub to be used like a single-member LLC that is disregarded for tax purposes.
Because LLCs also avoid double taxation but do not have owner eligibility restrictions, LLCs provide an attractive alternative to S corporations for most small businesses.
Number of Shareholders
An S corporation cannot have more than 100 shareholders.23 Counting the number of S corporation shareholders is not always straightforward. Several attribution rules group shareholders in different ways:
- Family ownership. The Internal Revenue Code may treat all members of a family as one person to determine the permissible number of shareholders.24 Under this rule, family includes common ancestors and lineal descendants of that common ancestor, and their spouses or former spouses.25
- Co-ownership. Individuals may co-own S corporation stock as tenants in common, joint tenants, tenancy by the entirety, or community property.26 If two spouses co-own S corporation stock—whether as community property or tenancy by the entirety—they are treated as a single shareholder under the family ownership rules discussed above. But unmarried individuals that co-own the stock as tenants in common or joint tenants are counted as separate shareholders.27
- Trust ownership. Special look-through rules apply to trusts. These rules treat the trust beneficiaries as shareholder. For voting trusts, each beneficiary is treated as a shareholder.28 For testamentary trusts, the estate is treated as the shareholder.29
- For grantor trusts, the grantor is treated as the shareholder.30 For QSSTs, the beneficiary is treated as the shareholder.31 For ESBTs, each potential beneficiary is counted as a shareholder.32
If, after applying these rules, a corporation has more than 100 shareholders, it is not eligible to be taxed as an S corporation.
One Class of Stock
Unlike C corporations, S corporations can only have one class of stock.
The corporation is treated as having only one class of stock if all shares of stock have identical right to distributions and liquidation proceeds and the corporation hasn’t issued any instrument or obligation or entered into any arrangement that may be treated as a second class of stock.33
The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds. A commercial contractual agreement, such as a lease, employment agreement, or loan agreement, is not a binding agreement relating to distribution and liquidation proceeds and thus is not a governing provision unless a principal purpose of the agreement is to circumvent the one class of stock requirement.
Differences in voting rights are disregarded for purposes of determining whether the corporation has more than one class of stock.34 If all shares of stock of an S corporation have identical rights to distribution and liquidation proceeds, the corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.35
Buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights unless:
- a principal purpose of the agreement is to circumvent the one class of stock requirement; and
- the agreement establishes a purchase price that, when the agreement is entered into, is significantly over or below the fair market value of the stock.36
Agreements that provide for the purchase or redemption of stock at book value or at a price between fair market value and book value are not considered to establish a price that is significantly in excess of or below the fair market value of the stock and are disregarded in determining whether the outstanding shares of stock confer identical rights. Similarly, bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation’s shares of stock confer identical rights.
The single-class-of-stock requirement frustrates may common business arrangements. S corporations cannot issue preferred equity with liquidation or distribution preferences. Any attempt by the S corporation to create different economic rights between the owners could disqualify the corporation from being taxed as an S corporation.
- I.R.C. § 1361(b)(1)(B), (C)
- I.R.C. § 1361(a)(1)(A).
- I.R.C. §§ 1361(b)(1)(D); 1361(c)(4).
- I.R.C. § 1361(b)(1).
- I.R.C. § 1361(b)(2)
- I.R.C. § 1361(b)(1)(B), (C)
- I.R.C. § 1361(c)(3)
- I.R.C. § 1361(b)(1)(B)
- I.R.C. §§ 1361(b)(1)(B), 1361(c)(6).
- I.R.C. § 1361(c)(2)(A)(iii)
- I.R.C. § 1361(c)(2)(A)(iv)
- I.R.C. § 1361(c)(2)(A)(i)
- I.R.C. § 1361(c)(2)(A)(ii)
- I.R.C. §§ 1361(d), 1361(c)(2)(A)(v)
- See I.R.C. § 1361(d)(3); Treas. Reg. § 1.1361-1(j)(1)
- See Priv. Ltr. Ruls. 200816002, 200816003, and 200816004 (Jan. 14, 2008)
- See I.R.C. § 1361(e)(1)
- I.R.C. 1 1362(d)(2)
- I.R.C. § 1361(b)(1)(C)
- I.R.C. § 1361(b)(1)(C); Treas. Reg. § 1.1361-1(g)(1)(i).
- I.R.C. § 1361(b)(3)
- I.R.C. § 1361(b)(3).
- I.R.C. § 1361(b)(1)(A)
- I.R.C. § 1361(c)(1)(A)(ii)
- I.R.C. § 1361(c)(1)(B)
- I.R.C. § 1361(b)(1)(B)
- Treas. Reg. § 1.1361-1(e)(1).
- I.R.C. § 1361(c)(2)(B)(iv)
- I.R.C. § 1361(c)(2)(B)(iii).
- I.R.C. § 1361(c)(2)(B)(i)
- I.R.C. § 1361(d)(1)(B)
- I.R.C. § 1361(c)(2)(B)(v)
- Treas. Reg. § 1.1361-1(l)
- I.R.C. § 1361(c)(4).
- Treas. Reg. § 1.1361-1(l)
- Treas. Reg. § 1.1361-1(l)(2)(iii).