Business Entities · S corporations

Requirements to qualify (e.g., qualifying shareholders)

The conditions for S status are five in number, they are cumulative, and each must hold on every day the election is in force rather than merely on the day it was made. That last point is what turns a definition into a compliance obligation: a corporation does not qualify once, it qualifies continuously, and a single transfer to the wrong holder ends the election on the day it happens.

The rule

The five conditions. a domestic corporation that is not an ineligible corporation and does not have more than 100 shareholders, does not have a shareholder who is not an individual other than an estate, a qualifying trust or a qualifying exempt organisation, does not have a nonresident alien shareholder, and does not have more than one class of stock (IRC § 1361(b)(1))^TY2026

How shareholders are counted. a husband and wife and their estates count as one shareholder, and all members of a family and their estates count as one — a family being a common ancestor, that ancestor's lineal descendants and the spouses and former spouses of either, with the common ancestor no more than 6 generations removed from the youngest generation of shareholders (IRC § 1361(c)(1))^TY2026

Which trusts may hold the stock. the trusts that may hold S corporation stock are a wholly grantor trust of a United States citizen or resident; that same trust after the deemed owner dies, but only for the 2-year period beginning on the day of death; a testamentary trust, but only for the 2-year period beginning on the day the stock is transferred to it; a voting trust; an electing small business trust; and, for bank stock only, certain individual retirement accounts (IRC § 1361(c)(2)(A))^TY2026

Voting differences do not count. Differences in voting rights among shares of common stock are disregarded in determining whether a corporation has more than one class of stock (IRC § 1361(c)(4)).

And a safe harbour for debt. Straight debt held by an individual, an estate, certain trusts or a person actively and regularly engaged in the business of lending money is not treated as a second class of stock (IRC § 1361(c)(5)).

Current figures

How it works in practice

Take the conditions in the order that produces answers fastest, which is not the order the statute lists them.

One class of stock is the condition most often broken by accident, because it is about economics rather than about certificates. What matters is that all outstanding shares confer identical rights to distribution and liquidation proceeds. Differences in voting power are expressly disregarded (IRC § 1361(c)(4)), so a corporation can have voting and non-voting common without difficulty. What creates a second class is unequal economic treatment: distributions made to one shareholder and not another, a buy-sell agreement fixing different prices, or a shareholder loan on terms that make it look like equity. The straight debt safe harbour in IRC § 1361(c)(5) exists precisely because the last of those was a recurring problem.

Permitted shareholders is a closed list and the exclusions matter more than the inclusions. An individual, an estate, certain trusts and certain exempt organisations may hold. A partnership may not. A corporation may not. A non-resident alien may not. That last one is the trap in a family company: a child who marries a non-resident alien and puts shares into the spouse’s name terminates the election on the day of the transfer.

The hundred-shareholder ceiling sounds binding and is in practice the loosest of the five, because of IRC § 1361(c)(1). A husband and wife and their estates count as one, and all members of a family and their estates count as one — a family being a common ancestor, that ancestor’s lineal descendants, and the spouses and former spouses of either, with the common ancestor no more than six generations removed from the youngest generation of shareholders. There is no election to make; a qualifying family simply is one shareholder. A company with two hundred natural persons on its register can be well inside the limit.

Domestic corporation and not an ineligible corporation are usually satisfied without thought, but the second is a defined term rather than a general standard: it reaches certain financial institutions, insurance companies and DISCs. A corporation that changes its business into one of those categories loses its election.

The point to carry away is the continuity requirement. Each of the five conditions is drafted as a present-tense description of the corporation, so failing any of them at any moment terminates the election under IRC § 1362(d)(2) on the date of cessation — not at the end of the year, and not on discovery.

Scenarios

How this has changed

The conditions have been liberalised steadily and the direction has been one way. The shareholder ceiling has risen from ten at the outset through several increases to its present figure; the family aggregation rule was added, and its formulation was changed from a narrower generational test to the current six- generation one; the range of permitted trusts has widened; and the safe harbour for straight debt was enacted to stop routine shareholder lending from destroying elections.

Two consequences follow for anyone reading older material. Any source describing a three-generation family test is describing pre-2005 law. And any source describing a shareholder ceiling below the current figure is describing a limit that has been raised more than once — the number is the single most frequently updated figure in subchapter S and the one most likely to be wrong in a secondary source.

The conditions themselves have not been relaxed in one respect: the permitted shareholder list still excludes partnerships, corporations and non-resident aliens, and no amendment has softened the immediate termination that follows a transfer to one of them. The relief route in IRC § 1362(f) for inadvertent terminations is the practical answer and has itself become more generously administered over time, but it is discretionary and it is not a substitute for the conditions being met.

Exam focus

The standard question lists four propositions about eligibility and asks which is not a requirement. The answer is nearly always the one that misstates the class-of-stock rule — “two classes designated A and B”, “different voting rights permitted”, and similar. One class is the requirement; voting differences are the exception to it.

The second reliable shape counts shareholders. Read for family relationships before counting names, and remember that spouses and their estates count as one and that a family counts as one.

Where a question describes a transfer to a partnership, a corporation or a non-resident alien, the answer is that the election terminates on the date of the transfer.

Check yourself

1. Which of these prevents a corporation from qualifying: 100 shareholders; two classes of stock differing only in voting rights; a non-resident alien shareholder; a domestic corporation?

Answer: the non-resident alien. IRC § 1361(b)(1)(C) excludes a corporation having a non-resident alien as a shareholder. One hundred shareholders is within the ceiling, which is “not more than 100”; classes differing only in voting rights are permitted by IRC § 1361(c)(4); and being domestic is a requirement rather than a disqualification.

2. A corporation has 118 registered shareholders. Ninety-two of them are descendants of one common ancestor, four generations back, together with their spouses. How many shareholders does it have for the 100-shareholder test?

Answer: 27. Under IRC § 1361(c)(1) all members of a family and their estates are treated as one shareholder, so the 92 count as one and the remaining 26 count individually. The common ancestor is four generations from the youngest generation of shareholders, within the six-generation limit.

3. An S corporation’s shares are held equally by two shareholders, one holding voting common and the other non-voting common with identical distribution and liquidation rights. Is there a second class of stock?

Answer: no. IRC § 1361(c)(4) provides that a difference in voting rights among shares of common stock is disregarded in determining whether a corporation has more than one class of stock. What creates a second class is a difference in the rights to distribution and liquidation proceeds.

4. On 3 August a shareholder transfers her shares to a limited partnership she controls. When does the election terminate?

Answer: on 3 August. A partnership is not a permitted shareholder under IRC § 1361(b)(1)(B), so the corporation ceases to be a small business corporation on that date, and IRC § 1362(d)(2)(B) makes the termination effective on and after the date of cessation. Relief may be available under IRC § 1362(f) if the circumstances were inadvertent and are corrected.

5. A shareholder lends the corporation money on a written note repayable on a fixed date at a fixed rate, not convertible into stock. Does this create a second class of stock?

Answer: no. IRC § 1361(c)(5) provides that straight debt is not treated as a second class of stock where it is a written unconditional promise to pay a sum certain on demand or on a specified date, the interest rate and payment dates are not contingent on profits or the borrower’s discretion, it is not convertible into stock, and the creditor is an individual, an estate, certain trusts, or a person actively and regularly engaged in the business of lending money.