When shareholders elect to make a corporation an “S corporation,” it’s essentially for tax purposes. With an S corporation, the business’s income and losses are “passed through” to the shareholders to report on their personal income taxes. This prevents “double taxation” for corporate income.
Specific requirements must be met to qualify as an S corporation under Internal Revenue Service (IRS) regulations. If a corporation no longer meets one or more of the requirements, the S corporation status is terminated. Let’s look at four things you need to avoid.
A shareholder who’s not allowed by the IRS
The IRS specifies that only individuals, estates and, in some cases, trusts are “allowable shareholders.” Further, “non-resident alien shareholders” aren’t allowed. If a shareholder sells their shares to an ineligible shareholder, such as someone who lives in another country, the corporation can no longer claim S status.
Having more than 100 shareholders
Since 100 is the maximum number of shareholders an S corporation can have, if one of them were to sell their shares to two different individuals, the S selection is revoked.
Having more than one class of stock
S corporations can only have one stock class. The only exception is that shareholders can have voting rights, but it isn’t required. Unfortunately, it is all too easy to create a new class by, for example, giving some shares a liquidation preference.
Having too much passive income
If you chose an S corporation election after being a C corporation and having retained earnings, your passive income can’t be 25% or more of your gross receipts for three consecutive years.
As you can see, it’s easier than you might imagine to lose your S corporation status. If you want to ensure that you retain it, you need to understand the requirements and have experienced legal and financial guidance as you go.