S corporations are separate legal entities from their shareholders and, under state laws, generally provide their shareholders with the same liability protection afforded to the shareholders of C corporations. For Federal income tax purposes, however, taxation of S corporations resembles that of partnerships. As with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually. Income is taxed at the shareholder level and not at the corporate level. The following requirements must be met to make an election to be treated as an S corporation:
- Must be an eligible entity such as domestic corporation, or a limited liability company.
- Must have only one class of stock.
- Must not have more than 100 shareholders. Spouses are automatically treated as a single shareholder. Families, defined as individuals descended from a common ancestor, plus spouses and former spouses of either the common ancestor or anyone lineally descended from that person, are considered a single shareholder as long as any family member elects such treatment.
- Shareholders must be U.S. citizens or residents, and must be natural persons, so corporate shareholders and partnerships are generally excluded. However, certain trusts, estates, and tax-exempt corporations, are permitted to be shareholders.
- Profits and losses must be allocated to shareholders proportionately to each one’s interest in the business.
Some states such as New York and New Jersey require a separate state-level S election in order for the corporation to be treated as an S corporation. If a corporation that has elected to be treated as an S corporation ceases to meet the requirements (for example, the number of shareholders exceeds 100 or an ineligible shareholder such as a nonresident alien acquires a share), the corporation will lose its S corporation status and revert to being a regular C corporation.