What are the limitations of "S" corporation status?

The total number of an S corporation’s shareholders must not exceed 75.

These shareholders are not permitted to be nonresident aliens. (They may, however, be resident non-U.S. citizens, estates or certain trusts. But residence in a U.S. territory or possession is not sufficient for qualification. The individual must be the resident of a state of the United States.)

S corporations must not have corporate, partnership or most trust-type shareholders. They must be either qualified individuals or the estates of deceased persons in the process of administration. Thus, an S corporation is not permitted to be a subsidiary of another corporation. The only exception to the rule is if it is a 100 percent-owned subsidiary of another S corporation.

S corporations may own subsidiaries but they must not own more than 80 percent of a non-S corporation subsidiary’s stock. They are permitted to own 100 percent of another S corporation.

S corporations must use the calendar year as their tax year unless an I.R.S.-approved business purpose–such as a highly seasonal business–can be established for a different taxable year. For example, the I.R.S. allows a variant fiscal year if it can be demonstrated that for three consecutive years 25 percent or more of the corporation’s gross receipts are realized during the last two months of the desired fiscal year. This fiscal year-end date must be September 30 or later.

Fringe benefits paid to shareholders who own two percent or more of the S corporation’s stock – such as medical reimbursement plans and group term life insurance – are not deductible corporate expenses under the latest federal tax laws, unless such expenses are reclassified as wage income to the greater than two percent owners.

While S corporation income is exempt from corporate tax at the federal level, not all states and territories exempt such corporations from state (or territorial) corporate taxes. States and territories that do not recognize S corporation tax status of S corporations incorporated in and/or operating in their jurisdiction include: The District of Columbia (Washington, DC), New Hampshire, Tennessee and Puerto Rico. These jurisdictions require S corporations to pay state (territorial or district) taxes at C-corporation rates.

Other states and territories that recognize S corporation status but nevertheless may require them to pay C corporation rates include: Arizona, Connecticut, Guam, Michigan, New Jersey, New York, Rhode Island and Vermont.

The majority of the states impose state income taxes on the shares of income of S corporations operating in their state that passes through to shareholders who reside out-of-state. Some states, including Delaware, require that an S corporation withhold state income taxes from distributions to nonresident shareholders. (In addition to adding to the accounting/bookkeeping workload, this might result in non-prorata distributions which in turn could lead to an I.R.S. finding that your corporation has more than one class of stock, in which case it could cause a retroactive termination of your federal S corporation election.)

S corporations are permitted to have only one class of common stock; however, this class may be divided into two categories: (1) Voting shares and (2) Nonvoting shares.

If you are converting an existing C corporation to S corporation status, to completely avoid C corporation income taxes, no more than 25 percent of its gross income may be derived from passive sources such as rent, dividends, interest, annuities, royalties, sales or exchange of securities.

However, if you are incorporating your enterprise from the beginning as an S corporation, it may earn as much passive income as you wish with no limitations.

When a C corporation switches to S status and later disposes of an asset of the C corporation that became an asset of the new S corporation, it must pay taxes on the “built-in gain” it benefited by at the time of the S election.

If you have a C corporation that has appreciable assets and plan to elect S corporation status, you should obtain an independent professional appraisal of both the bulk sale (wholesale) value and retail value of such assets at the time of S election.

With an S corporation, shareholders are taxed on their shares of corporate earnings whether they take these earnings as dividend distributions or retain the earnings in the corporation. All earnings (profits) must pass through to shareholders, at least on paper. In other words, even though the corporate profits for a given year remain physically in the corporate bank account – to build up working capital, for example – and are never transferred to the shareholder(s), each shareholder must nevertheless pay personal income tax on his/her share of those profits, which will be considered by the I.R.S. to be: (1) individual income and (2) paid-in capital.