Who is Considered Allowable Shareholders in an S-Corp?

As you may already know from one of our other articles, making the S-Corp election and keeping S-Corp status comes with some specific eligibility requirements as well as ongoing requirements to uphold. One of these requirements, set out in Section 1361 of the Internal Revenue Code, is that an S-Corporation must have only allowable shareholders.

Many small business owners, like yourself, may wonder, “But who is an allowable shareholder?” Luckily, that is what we’re here to explain. We covered the quick answers in one of our articles, “Who Can Make the S-Corp Election?”, so be sure to check that out, if you haven’t already, to learn about all of the eligibility requirements for a small business who is looking to start saving money on their small business taxes by making the S-Corp election. Or you can give our CPA firm a call and let our accounting services for small businesses answer all your questions about the S-Corp election and handling your small business taxes.

Allowable Shareholders in an S-Corp

U.S. Citizens
U.S. Permanent Residents
Single-Member LLC’s owned by one of the above
Certain Trusts, Estates, and Non-Profits

Keep in mind that who your shareholders are is only part of the test. An S-Corp also may not have more than 100 shareholders, though for that count all members of a family are treated as one shareholder — a common ancestor, their lineal descendants, and the spouses (or former spouses) of either, so long as the common ancestor is no more than six generations removed from the youngest generation of shareholders. And an S-Corp may have only one class of stock, although differences in voting rights alone do not create a second class. Both rules come straight from IRC §1361(b), and the IRS restates them in the Form 2553 instructions.

The list of allowable shareholders is pretty straightforward for the first three points above, but when we get to the fourth point it gets a little more in the weeds. “Certain” trusts, estates and non-profits isn’t exactly a clear definition of what those are. That’s where we come in as experts on all things S-Corp accounting related.

Estates that are Considered Allowable Shareholders in an S-Corp

An estate is not an allowable shareholder unless the estate is that of a shareholder who is deceased or has fallen into bankruptcy. In these cases, the estate assumes the shareholder role while the estate is in existence. This time period is not defined, but is typically as long as is reasonable for the particular estate to be settled. During this time, the S-Corp shares could also transfer to an allowable trust, which becomes the shareholder.

Trusts that are Considered Allowable Shareholders in an S-Corp

Revocable trusts created as part of an estate

The estate may hold the S-Corp stock when a shareholder dies or falls into bankruptcy

Grantor trusts

These trusts must meet certain requirements, listed in IRC §1361(c)(2), including that it has one deemed owner who owns the entire trust and who is a U.S. citizen or permanent resident. Additionally, the trust remains an allowable S-Corp shareholder for two years after the owner of the grantor trust dies. After which, the trust must distribute the stock to an eligible shareholder or qualify as an ESBT or QSST.

Testamentary trusts created by a will

These trusts are established by a will of the deceased and may receive S-Corp shares when the estate of the deceased is the S-Corp shareholder for two years after the transfer. After which, like grantor trusts, they must distribute the stock to an eligible shareholder or qualify as an ESBT or QSST.

Qualified subchapter S trusts (QSSTs)

These trusts must not be used to benefit multiple beneficiaries (unless each beneficiary is treated as owning a separate share of the trust) or accumulating income. The trust must distribute all current income to a beneficiary who is a U.S. citizen or permanent resident, and under IRC §1361(d) the beneficiary (or their legal representative) — not the trustee — must file the QSST election with the IRS.

Electing small business trusts (ESBTs)

Under IRC §1361(e), an ESBT’s beneficiaries must all be individuals, estates, or certain charitable organizations, no interest in the trust may be acquired by purchase, and the trustee must file the ESBT election with the IRS. One notable exception since 2018: a nonresident alien is allowed to be a potential current beneficiary of an ESBT without terminating the S-Corp election, even though a nonresident alien can never own S-Corp stock directly.

Voting Trusts

This type of trust is formed for the purpose of exercising the voting power of stock transferred. The beneficiaries are treated as the owners of their respective portions. Additionally, to qualify as an S-Corp shareholder, the formation of the voting trust must come from a written agreement that satisfies four requirements under Treasury Regulation §1.1361-1(h).

1. It delegates the right to vote to one or more trustees.
2. It requires that the beneficial owners of the S-Corp stock receive payment for all distributions from the stock of the corporation.
3. It requires that upon trust termination, title and possession of the stock is to be delivered to the beneficial owners.
4. It is in accordance with the terms of the trust or state law to terminate on or before a specific date or event.

Exempt Organizations that are Considered Allowable Shareholders in an S-Corp

Non-profit businesses that have been recognized by the IRS as being tax-exempt by virtue of its charitable programs and qualifies under 501(c)(3) is considered an allowable shareholder in an S-Corp. The only other tax-exempt organizations that qualify under IRC §1361(c)(6) are qualified retirement plan trusts described in section 401(a), such as an employee stock ownership plan (ESOP). Other tax-exempt entities — a 501(c)(4) social welfare organization or a 501(c)(6) trade association, for example — are NOT allowable S-Corp shareholders.

NOT Allowable Shareholders in an S-Corp

C Corporations and Partnerships
Nonresident Aliens
Foreign Trusts
Multiple Member LLCs
Limited Liability Partnerships
Individual Retirement Accounts (outside of a narrow exception for certain IRAs holding stock in a bank S-Corp)

Things can get tricky and complicated quickly when dealing with estates, corporations, trusts, etc. as shareholders in an S-Corp. Hopefully we’ve answered some of your questions. Trusts, particularly types that are formed or affected by the death or bankruptcy of the shareholder can have complex ramifications and requirements; a bit of planning and professional help can save you, your small business, and other shareholders a lot of headaches in the future.

Every situation is different, and if you are dealing with any situation concerning an S-Corp, we recommend giving us a call to talk to a live CPA or bookkeeper who specializes in S-Corp accounting and small business taxes so that we can give you the best advice for your unique situation.