Is it possible to lose "S" corporation status?

Yes. You may lose it automatically if you violate the I.R.S. rules. For example, you can lose it if you have 75 shareholders and one of your shareholders gives a share of stock to someone else – even a member of a family, such as a child – causing you to exceed the shareholder number limit, unless the I.R.S. decides to waive the automatic termination that results under the law.

Note that when a husband and wife own stock as “tenants in common,” or “joint tenants,” or, as “community property,” they are counted by the I.R.S. as one shareholder in terms of this S corporation requirement. However, if the spouses own the shares individually, they are counted as two shareholders – even if they also own some stock in the corporation jointly. If either spouse, but not both, owns shares individually as well as jointly, these two individuals count as one shareholder. And, if two shareholders not legally married own stock jointly, the I.R.S. counts them as two shareholders.

If you issue a second class of stock, your S corporation can automatically become a C corporation with corporate tax liability. Note that if your S corporation’s shareholders lend too much money to the corporation, rather than investing the money in stock as capital at risk, the I.R.S. may nevertheless deem the loan to be an investment in stock and rule that stock to be of a different class than the one originally issued. Consequently, your S corporation will be viewed as having more than one class of stock and will lose its S status. The single case in which you are allowed to have two classes of stock is when you issue both voting and nonvoting stock.

You lose S status if another corporation, partnership or certain types of trust become a shareholder.

If, even without your knowledge, a share of stock should be transferred to a nonresident alien, your S corporation could become a C corporation, if the I.R.S. decides not to exercise their statutory permission from Congress to waive inadvertent termination of your S status.

The best way to prevent such an occurrence is to incorporate as a “Close” corporation and to include in your corporate bylaws specific rules for stock transfer, including the notification of the president and/or treasurer and/or secretary of the name, permanent residence address and citizenship status of the purchaser of any shares of stock sold by any shareholder.

You can also state in your bylaws that your S-corporation stock “may not be sold to any individual or entity, the sale to whom or which would result in the loss of S-corporation status.” Or, you can simply state “All stock held by shareholders, when offered for sale, must first be offered to the corporation and/or its shareholders who shall have the right of first refusal for a period of thirty (30) days.”