S Corporation Basics
The S corporation is a great tool for many small businesses to explore. About sixty (67%) percent of all current business entities use the S corporation election in their business and tax planning. However, not every entity can qualify for the S corporation election. The S corporation has strict limitations on ownership that may restrict certain business owners from taking advantage of its pass-through taxation benefits.
For instance, there are very few permitted shareholders. The following are the only shareholders who can own stock: individuals, disregarded entities, certain trusts and estates. Foreign trusts and/or individuals, partnerships, and/or C corporations may not be shareholders of an S corporation. Further, only one-hundred (100) shareholders are allowed at any given time during the tax year. The prior law was not so generous. In 1978, the S corporation was only able to have fifteen (15) shareholders. In 1981, Congress raised the limit to twenty-five (25) shareholders. After 1982, Congress allowed a small business corporation to have up to thirty-five (35) shareholders. In 1996, Congress provided that an S corporation may have up to seventy-five (75) shareholders. Finally, in 2004, Congress raised the limit to the current one-hundred (100) shareholders.
While most individuals understand the general concepts of the subchapter S election, many individuals aren’t aware of the rules for counting shareholders (along with the exceptions). Specifically, a husband and wife are counted as one shareholder. “Common ancestors” are counted as one shareholder. Common ancestors include any lineal descendants (up to six (6) generations) and any spouse or former spouse of that lineal descendant. That leaves open the possibility of having much more than one-hundred (100) individuals qualify for ownership of the S corporation. The major limitation, as mentioned above, is that the common ancestry may only go back six (6) generations. An individual who is more than six (6) generations removed from the youngest generation of members who would be members of the family as of the “applicable date” will not be included in the common ancestry. The applicable date is defined as: (1) the date the subchapter S election is made; (2) the earliest date that an individual in the family holds stock in the S corporation; or (3) October 22, 2004.
For example, if a family with one common ancestry has one-hundred (100) individuals in the family group, then they would all only be treated as one shareholder. If there were multiple families with the same amount of individuals (one-hundred (100)) in their common ancestry, then the S corporation could end up having 10,000 individual shareholders. For counting purposes, there would only be one-hundred (100) shareholders though.
In conclusion, there are many nuances when it comes to S corporations. Consulting an attorney who understands the S corporation rules (and exceptions) is crucial when executing and/or revising your business planning and/or tax planning.
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