The Complete Guide to S-Corporation Shareholders [Updated for 2023]

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You’ve heard about how great S corporations can be, but you still have some questions. Specifically, you want to know more about S corporation shareholders and their roles and responsibilities.

S corporations are one of the best structures for small business owners. They allow for payroll tax savings and provide audit protection.

However, before setting up an S corporation, ensure you understand the rights and tax issues relating to shareholders. Let’s get started.

S-Corporation basics

S-corporations (S-corps) are a popular type of business structure in the United States that offer several advantages, including pass-through taxation, limited liability protection, and the ability to split profits and losses among shareholders. In this article, we’ll focus specifically on S-corporation shareholders and everything you need to know about their role in the business.

First and foremost, it’s essential to understand that an S-corporation is a type of corporation taxed differently than a traditional corporation (C-corp). While C-corps pay taxes on their corporate income, S-corps are pass-through entities, meaning the business does not pay income tax.

Instead, the company’s profits and losses are “passed through” to the shareholders and reported on their individual tax returns. This means that shareholders are responsible for paying taxes on their share of the company’s profits, even if they do not receive any distributions or dividends.

Who Can Be an S Corporation Shareholder?

So, who can be a shareholder in an S-corporation? Any individual or entity that meets the eligibility requirements can become a shareholder. This includes individuals, trusts, estates, and specific tax-exempt organizations. However, it’s important to note that some types of businesses, such as partnerships and other corporations, are not eligible to be S-corporation shareholders.

The following entities can be an S corporation shareholder:

  • U.S. citizens and also permanent residents
  • Single-member LLCs that are owned by U.S. citizens or residents
  • Grantor trusts
  • Certain voting rights trusts
  • Bankruptcy trusts
  • Will-created testamentary trusts
  • Certain tax-exempt organizations
  • Certain trusts under subchapter S law
  • Estate-created revocable trusts

These entities and individuals cannot own S corporation shares:

  • Non-resident aliens
  • Foreign trusts
  • Partnerships
  • Business trusts
  • LLCs with more than one LLC member
  • Limited liability partnerships (LLPs)
  • C corporations
  • Individual retirement accounts (IRAs)

To become a shareholder in an S-corporation, you must first purchase shares of stock in the corporation. The number of shares you have will determine your percentage of ownership in the corporation. For example, if the corporation has 1,000 shares of stock and buys 100 shares, you will own 10% of the corporation.

To become a shareholder, you must also meet the eligibility requirements for S-corporation status. This includes being a U.S. citizen or resident and having no more than 100 shareholders. Additionally, all shareholders must agree to the S-corporation status and file Form 2553 with the IRS.

It’s important to note that not all corporations are eligible for S-corporation status. For example, corporations with multiple classes of stock, such as preferred and common stock, are not eligible for S-corporation status. Corporations with more than 25% of their income from passive sources, such as rental income, may not be eligible for S-corporation status.

Rights and Responsibilities of S-Corporation Shareholders

S-corporation shareholders have various rights and responsibilities outlined in the corporation’s bylaws and shareholder agreements. Some of the most fundamental rights and duties of S-corp shareholders include:

  1. Voting Rights: S-corp shareholders have the right to vote on major decisions affecting the corporation, such as electing the board of directors, approving significant changes to the corporation’s bylaws, and approving the sale or merger of the corporation.
  2. Dividends and Distributions: S-corp shareholders are entitled to receive a share of the corporation’s profits through dividends or distributions. The amount of dividends and distributions each shareholder receives is typically based on their percentage of ownership in the corporation.
  3. Liability Protection: S-corp shareholders are not personally liable for the corporation’s debts. This means their personal assets are protected from any legal action against the corporation.
  4. Shareholder Meetings: S-corp shareholders can attend and vote at shareholder meetings. Shareholder meetings are typically held annually and allow shareholders to discuss the corporation’s state, elect directors, and make critical decisions affecting the corporation.

Shareholder liability

One of the advantages of being an S-corporation shareholder is the ability to split profits and losses among multiple owners. Unlike a sole proprietorship or partnership, where all profits and losses are attributed to one or more individuals, S-corporation shareholders can share in the company’s success or failure based on their percentage of ownership. This can provide a level of protection against financial risk, as shareholders are not personally liable for the company’s debts and obligations.

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However, it’s important to note that S-corporation shareholders are not immune to all forms of liability. While they are generally protected from personal liability for business debts and obligations, they can still be held liable for their own actions as shareholders. For example, if a shareholder engages in fraudulent or illegal activities that harm the business or others, they may be held personally liable for any damages that result.

Taxation of S-Corporation Shareholders

One of the significant benefits of operating as an S-corporation is pass-through taxation. This means the corporation’s profits and losses are passed through to the shareholders/owners and reported on their tax returns. S-corp shareholders are taxed on their share of the corporation’s profits at their individual tax rate, potentially resulting in a lower overall tax liability than a traditional corporation.

It’s important to note that S-corp shareholders must pay themselves a reasonable salary for the work they perform for the corporation. This salary is subject to payroll taxes, such as Social Security and Medicare taxes. Any profits distributed to shareholders beyond their salary are considered dividends and not subject to payroll taxes.

Final thoughts

S-corporation shareholders have various rights and responsibilities, including voting rights, entitlement to dividends and distributions, and liability protection. Additionally, S-corp shareholders are subject to pass-through taxation, meaning their profits and losses are reported on their individual tax returns.

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