An S corporation is a corporation that elects to pass its income, losses, deductions, and credits through to its shareholders, avoiding corporate‑level tax. § 1363(a). But to qualify, the corporation must meet strict requirements.
Under § 1361(b), an S corporation can have:
- No more than 100 shareholders.
- Only individuals, estates, certain trusts, and tax‑exempt organizations as shareholders.
- No nonresident alien shareholders.
- Only one class of stock.
What does “one class of stock” mean? The corporation can have voting and nonvoting common stock – that’s still one class. § 1361(c)(4). But all outstanding shares must have identical rights to distribution and liquidation proceeds. Reg. § 1.1361‑1(l)(1).
Certain arrangements can create a second class of stock:
- Buy‑sell agreements that fix a price significantly above or below fair market value.
- Debt instruments that are treated as equity.
- Calls or convertible debt that are “substantially certain” to be exercised.
But there are safe harbors. “Straight debt” – a written, unconditional promise to pay a sum certain on a specified date – is not a second class of stock. § 1361(c)(5). And unwritten shareholder advances of $10,000 or less, expected to be repaid within a reasonable time, are also safe. Reg. § 1.1361‑1(l)(4)(ii)(B)(1).
If you want to operate as an S corporation, you need to be meticulous about your capital structure. Any variation in rights can blow the election.
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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