Can Your Business Operate as an S Corporation?

Almost four million small businesses have elected to be treated as S corporations for tax accounting purposes. And for simple reasons. An S corporation doesn't pay corporate income taxes. And an S corporation often saves shareholder-employees thousands of dollars a year in Social Security and Medicare payroll taxes.

That's good news if you're a small business owner. But there's bad news, too, when you start talking about S corporations. You need to meet a number of qualifications in order to be treated as an S corporation, as outlined in the following paragraphs.

S Corporations Must Be Domestic U.S. Corporations

The first qualification is that only U.S. domestic corporations are eligible to become S corporations. A domestic corporation is one formed according to the laws of one of the states (for example, California) and not a foreign corporation formed in, say, Japan or France.

S Corporations Can Have Only a Limited Number of Shareholders

A second S corporation qualification relates to the number of shareholders. In order to be treated as an S corporation, the business must have 100 or fewer shareholders.

You do have a bit of wriggle room in this "100 or fewer" test, however. A family group typically counts as a single shareholder. A family includes a parent, his or her children, grandchildren, great-grand children and so on through the great, great, great grandchildren. Also, a husband and wife who both own S corporation stock count as a single shareholder.

S Corporation Shareholders Must Be U.S. Citizens or Permanent Residents

Another shareholder qualification exists for S corporations, too. In general, the owners, or shareholders, of an S corporation can be only individuals who are U.S. permanent residents or citizens. In other words, you can't use the S corporation option if one of your shareholders is non-US taxpayer.

Note, however, that a handful of special exceptions to the rule about "individual U.S. taxpayers" exist. A U.S. taxpayer's estate after he or she passes away and a U.S. taxpayer's testamentary trusts can both be S corporation shareholders. So can a U.S. taxpayer's bankruptcy estate. Also, in some special circumstances, a charity can also own S corporation stock and so can another S corporation.

And, just to make this point, while S corporations can own shares in partnerships or regular corporations, partnerships and regular corporations can't own shares in an S corporation.

S Corporations Can Have Only One Class of Stock

Another qualification for becoming an S corporation is that the corporation can have only a single class of stock. The single-class-of-stock requirement can get tricky, but what it really means is that profits or losses--both those that occur over the time the corporation operates and those that occur when the corporation liquidates--must be distributed based on the ownership percentage.

If a shareholder owns 10% of an S corporation, for example, he or she should get 10% of the operating profit each year and 10% of any distributions of that profit. Similarly, when an S corporation liquidates, any profit and distributions paid at liquidation should be based on the ownership percentages.

Note that an S corporation can have nonvoting stock because not being able to vote doesn't affect a shareholder's shares of profit, loss and distribution. Also, an S corporation can pay different employees (including shareholder-employees) different salaries.

S Corporations Can't Appear on the Prohibited S Corporation List

One final qualification to being an S corporation needs to be mentioned. A handful of corporations are prohibited, just as a matter of tax law, from electing to be treated as S corporation. The list includes insurance companies taxed under Subchapter L of the Internal Revenue Code, financial institutions using the "Sec. 585 reserve method" for dealing with bad debts, domestic internal sales corporations, and (finally) a corporation that's taken the Puerto Rico and possessions tax credit for doing business in a U.S. possession.