S Corporation Requirements: Everything You Need To Know

S Corporations, or S Corps for short, is popular among small and medium-sized businesses in the United States. An S Corporation provides legal protections to owners while avoiding double taxation. However, to qualify for S Corporation status, businesses must meet certain eligibility criteria and comply with various requirements set forth by the IRS. This article will explore everything you need about S Corporation’s requirements.

What is an S Corporation? Understanding the Basics

An S Corporation is a business entity that combines a corporation’s liability protection with a partnership’s tax benefits. In an S Corporation, profits and losses are passed through to the shareholders, who report them on their personal tax returns. This means the corporation is not subject to double taxation on its income.

To qualify for S Corporation status, a business must meet specific eligibility criteria, such as having no more than 100 shareholders and issuing only one class of stock. Additionally, the corporation must comply with various requirements set forth by the IRS.

S Corporations are popular among small and medium-sized businesses due to their tax benefits and liability protection. However, they also come with increased administrative and compliance requirements.

Requirements for S Corporation

To qualify for S Corporation status, a business must meet the following requirements:

1. Be a domestic corporation: Only corporations formed in the United States or its territories are eligible for S Corporation status.
2. Have no more than 100 shareholders: S Corporations are limited to a maximum of 100 shareholders, all of whom must be individuals, certain types of trusts, or estates.
3. Have only one class of stock: S Corporations are limited to issuing only one class of stock. This means that all shareholders must have equal distribution rights and voting power.
4. Be owned by eligible shareholders: S Corporation shareholders must be either U.S. citizens or residents, certain types of trusts, or estates. Nonresident aliens, partnerships, and corporations are not eligible to be shareholders.
5. Use a calendar year for tax purposes: S Corporations must use a calendar year as their tax year unless they can demonstrate a business purpose for using a fiscal year.
6. Obtain shareholder consent: To elect S Corporation status, all shareholders must sign and file Form 2553 with the IRS within two months and 15 days of the start of the tax year in which the election is to take effect.
7. Comply with ongoing requirements: S Corporations must meet ongoing needs, such as filing annual tax returns and maintaining accurate records.

Meeting these requirements is essential for maintaining S Corporation status and avoiding potential tax penalties. 

Domestic Corporation Requirements

Domestic corporation requirements refer to the essential criteria a corporation must meet to be considered a “domestic corporation” and operate within the United States. These requirements include:

1. Formation and Registration: The corporation must be formed correctly following the laws of the state in which it is incorporated and must be registered with the appropriate state agencies.
2. Physical Presence: A US corporation must have a physical presence, like a registered office or place of business, to operate legally.
3. Ownership: The corporation must be owned and controlled by U.S. citizens, residents, or other domestic corporations that meet the requirements.
4. Tax Status: The corporation must comply with all federal, state, and local tax requirements, including registration for and payment of applicable taxes.

Meeting these requirements is essential for a corporation to operate legally within the United States as a domestic entity. Consulting with a qualified attorney or accountant must ensure your corporation complies with applicable laws and regulations.

Shareholder Limits Requirements

Shareholder limits restrictions on the number and type of shareholders for S Corporation qualification. S Corporations must have 100 or fewer shareholders, individuals, certain trusts, or estates.

This requirement ensures that S Corporations remain small and closely-held entities instead of large publicly-traded corporations. Additionally, all shareholders must be U.S. citizens or residents, certain types of trusts or estates. Nonresident aliens, partnerships, and corporations are not eligible to be shareholders.

It is important to note that the 100-shareholder limit applies to the number of individual shareholders, not the number of shares. For example, a single shareholder may own multiple shares but still only count as one shareholder for S Corporation purposes.

One Class of Stock Requirements

The one class of stock requirement is a key requirement for S Corporation status. To be eligible for S Corporation status, a corporation must always have only one class of stock outstanding. This means that all shares of stock must have equal rights to distributions, liquidation proceeds, and voting power.

In other words, all shareholders must be treated equally concerning their ownership interests in the corporation. The one class of stock requirement ensures equal economic interests for all shareholders and prevents potential favoritism towards certain shareholders.

There are a few exceptions to the one class of stock requirement. For example, certain types of stock that are not voting or have limited voting rights may be allowed as long as they do not create a second class of stock. Additionally, the corporation may issue different classes of stock if they are convertible into a single class of common stock.

Qualified Shareholders Requirements

Qualified shareholders’ requirements refer to the eligibility criteria that shareholders must meet to hold shares in an S Corporation. To be considered an eligible shareholder, an individual or entity must meet the following requirements:

1. Be a U.S. citizen or resident: S Corporation shareholders must be either U.S. citizens or residents for tax purposes. Nonresident aliens are not eligible to hold shares in an S Corporation.
2. Not be a partnership or corporation: Partnerships and corporations are not eligible to hold shares in an S Corporation. However, certain types of trusts, such as grantor trusts, are eligible.
3. Meet the 100-shareholder limit: S Corporations are limited to a maximum of 100 shareholders. Therefore, any individual or entity that wishes to hold shares in an S Corporation must be within this limit.
4. Not be an ineligible corporation: Certain types of corporations, such as domestic, international sales corporations (DISCs), and passive foreign investment companies (PFICs), are not eligible to hold shares in an S Corporation.

Fiscal Year Requirements

Fiscal year requirements refer to the rules S Corporations must follow when selecting their fiscal year for tax purposes. S Corporations must use a calendar year as their tax year when they report their income and expenses to the IRS. However, in some cases, an S Corporation may be allowed to use a fiscal year instead.

The S Corporation must demonstrate a valid business purpose to use a fiscal year. For example, a corporation with a seasonal business may benefit from using a fiscal year that better aligns with its revenue-generating periods.

If the S Corporation is eligible to use a fiscal year, it must follow certain requirements:

1. File Form 1128: The corporation must file Form 1128 with the IRS to request permission to use a fiscal year. This form must be filed by the due date of the S Corporation’s tax return for the year before the asked for the fiscal year.
2. Obtain IRS Approval: The IRS must approve the S Corporation’s request to use a fiscal year. Approval is generally granted if the corporation can demonstrate a valid business purpose.
3. Maintain Consistency: Its reporting must be consistent once the S Corporation approves using a fiscal year. This means it must continue using the same fiscal year unless it can demonstrate another valid business purpose for changing it.

Meeting these fiscal year requirements is essential for maintaining S Corporation status and avoiding potential tax penalties.

Passive Income Requirements

Passive income requirements refer to the limits on passive income an S Corporation can earn each year. This income is earned without active involvement in the business, such as rental income, interest income, and dividends.

To maintain S Corporation status, the corporation must meet the following passive income requirements:

1. Less than 25% of gross receipts: The S Corporation must earn less than 25% of gross receipts from passive sources during the tax year. Gross receipts include all the corporation’s income, whether from passive or active sources.
2. Limited exceptions: Certain types of passive income, such as royalties, may be excluded from the 25% calculation. Additionally, if the S Corporation has not been in business for the entire tax year, a prorated amount of the 25% limit may apply.

Suppose the S Corporation earns more than 25% of its gross receipts from passive sources. In that case, it may lose its S Corporation status and become subject to different tax rules, including the potential for double income taxation.

Tax Treatment Requirements

Tax treatment requirements refer to the rules and regulations an S Corporation must follow to qualify for certain tax benefits. Specifically, an S Corporation is subject to the special tax treatment that allows it to avoid double taxation of income, meaning that corporate income is taxed only once at the shareholder level.

To qualify for this special tax treatment, an S Corporation must meet the following tax treatment requirements:

1. File Form 1120S: The S Corporation must file Form 1120S each year to report its income and expenses to the IRS.
2. Pass-through taxation: The S Corporation must pass its income and losses to its shareholders, who report this income on their tax returns. The corporation is not subject to federal income tax at the corporate level.
3. Shareholder income and losses: Each shareholder’s share of the S Corporation’s income and losses must be determined based on their pro rata share of the corporation’s stock.
4. Distributions: Distributions made to shareholders must be proportional to their share of the corporation’s stock.
5. Limited deductions: The S Corporation may only take certain deductions, such as those for employee compensation and fringe benefits.

Conclusion

S Corporations offer small and closely-held businesses a unique opportunity to avoid double-income taxation and benefit from pass-through taxation. However, to maintain S Corporation status and qualify for these benefits, the corporation must meet several requirements.  It includes shareholder limits, one class of stock, and passive income limitations. Additionally, the corporation must follow specific tax treatment requirements. For example, filing Form 1120S, passing through income and losses to shareholders, and limiting deductions. Meeting IRS requirements is crucial for S Corporations to comply with regulations and avoid tax penalties.