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How to Form and Operate an S Corporation

S corporations are a great option if you are looking for a simple business structure. S corporations allow only the allowable number of members and shareholders. In other words, you cannot have any non-resident aliens as members or shareholders. To form an S corporation, you must file an election form with the IRS. This relatively easy business structure allows you to keep the paperwork simple.

Limitations on shareholders

There are certain limitations on the number of shareholders an S corporation can have. Before 2004, this limit was set at 75. However, the number increased to 100 after that date. In addition, a shareholder must also meet certain conditions to own stock in an S corporation. Listed below are some of those restrictions.

A shareholder in an S corporation can be a single individual, a married couple, or a trust. Those shareholders must have rights equal to those held by their shares of stock in the corporation. These restrictions are the same as those for a regular corporation.

Limitations on investors

An S corporation has certain limitations regarding the types of investors it can have. For example, it cannot issue any stock to foreigners. It can also have only 100 shareholders, and all of them must be either U.S. citizens or resident aliens. Also, it cannot accept equity financing from foreign investors or issue profit interests to shareholders. Despite these limitations, S corporations are popular for small businesses, including family businesses.

However, one major benefit of operating an S corporation is that it can simplify the exit process. Because it doesn’t rely on the owner’s involvement, it is easier to sell or transfer the company. The downside is that S corporations are subject to many rules, and many businesses may not be able to comply with all of them. The restrictions include the following:

  • limiting the number of shareholders to 100.
  • having only one class of stock.
  • paying shareholders a reasonable salary based on market conditions.

Limitations on stock classes

Limitations on stock classes for an S corporation are generally nonexistent, but they can be a problem if you want to expand the ownership of your business. There are some ways to expand ownership of your business without violating the law. For example, key employees can buy in and become stockholders. You can also establish a graduated buy-in system.

The tax code permits a company to issue voting and non-voting stock as long as the total number of shares in all classes is equal. However, if your company has more than one class of stock, it will lose its S status and will no longer be able to claim many benefits. For example, to qualify for S status, all your shares must have equal rights to operating and liquidating distributions. The way you determine whether or not you can have more than one class of stock is a matter of analyzing your corporate charter, bylaws, and any other binding agreements.

Limitations on foreign owners

If a corporation wants to retain its status as an S corporation, it must be careful when selling shares to foreign individuals. Although foreign owners may qualify as exempt individuals under the Internal Revenue Code, the rules do not permit them to own more than 100 percent of the company. However, they are allowed to own shares of S corporations owned by one or more U.S. citizens.

The Tax Cuts and Jobs Act of 2017 removed the limitation preventing non-resident aliens from becoming S corporation shareholders. While non-resident aliens can no longer be direct shareholders of an S corporation, they can still be indirect shareholders through an ESBT.

Limitations on self-employment tax

While the S corporation tax break is beneficial for many self-employed individuals, it also comes with its own set of limitations. For example, you can only claim 20% of your profit as a deduction for tax years 2018-2025. Moreover, you must pay yourself a reasonable salary that reflects the average salary range of your position.

One of the major differences between an S corporation and a partnership is the employment status of the active owners. If the owners perform more than minor services for the company, they are considered employees for tax purposes. As such, an active S corporation owner wears two different hats.

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