S corp stock may be issued to owners of s corporation types of business entities. 3 min read updated on September 19, 2022
S corp stock may be issued to owners of s corporation types of business entities. An S corporation is similar to a standard corporation, but it has a tax advantage in that it is not subject to income taxes at the corporate level. Instead, shareholders report profits and losses on their personal income tax returns.
Because the S corporation is intended by federal law for small business use, strict rules have been established about the issuance of S corporation stock. For this reason, it is not necessarily the best business entity for certain entrepreneurs. It's important to understand the pros and cons of the various types of business entities before you decide which one is best for your business.
Classes of Stock
An S corporation may only issue one class of stock, with each share representing an equal ownership stake. For example, this business entity cannot establish a stock class that gets dividends and a stock class that does not. The only exception is that different shareholders can have different voting rights. This is often used when shareholders of a family-owned S corporation want to pass down their ownership stakes while retaining control via voting power.
An S corporation is limited to 100 shareholders, although family members can be counted as a single shareholder. This designation includes a descendant of an ancestor within six generations, a spouse or prior spouse of an ancestor, or any descendant. For example, if a married couple, their children and the children's spouses, and the grandchildren and their spouses agree to be treated as one owner, they can all be counted as a single shareholder. Restrictions exist on when shares can be sold and to whom.
Allowable Stockholders
IRS restrictions on S corporation shareholders are as follows:
- They must be U.S. citizens or residents.
- They must be individuals or certain estates, domestic trusts, or tax-exempt organizations.
- Certain types of trusts that can act as shareholders include grantor trusts, electing small business trusts, and qualified subchapter S trusts.
If any shareholder does not meet these requirements, S corporation status is at risk of being revoked.
Results of Violations
An S corporation can lose its favorable tax status if it violates restrictions on the number of stock classes or the number or type of shareholders. If this happens, the S corporation reverts to a C corporation and is thus subject to corporate income tax. All company distributions are taxed as dividends and losses cannot be reported on the shareholder's personal return. What's more, S corporation status is revoked for a period of five years with no exceptions.
If you opt to establish an S corporation, it's important to understand the difference between authorized and issued shares. Corporations are formed by drafting and submitting articles of incorporation to the appropriate secretary of state. These legal documents must include certain information about your new corporation, including how many authorized stock shares it will have. This is important because of the rules about share ownership. Changing the number of authorized stock shares requires an amendment to the articles of incorporation.
However, S corporations don't necessarily need to issue all their authorized shares. It's wise to set aside a portion that can be offered to future investors, without having to amend the articles of incorporation with a shareholder vote to increase authorized shares. The company can also raise the number of issued shares with a stock dividend as long as the total number doesn't exceed the number of authorized shares. Being strategic about the use of authorized and issued shares can help your company raise money in the future.
S Corporation Stock Basis
The measured amount of investment a stockholder has in a property is known as his or her basis. This starts out equal to the total cost of the property, but changes along with the shareholder's individual investment in the company. While the stock basis of a C corporation is the same year to year, for an S corporation, this number is impacted by distributions, loans, and annual income. You should track it from year to year to avoid surprises.
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