An S-corporation is a business entity in which all of the corporate income, losses, deductions, and credits each year are passed through to the shareholders for federal tax purposes. Shareholders of S-corporations must report the flow-through income and losses on his or her personal tax returns and are assessed tax at his or her respective individual income tax rates; this avoids double taxation on corporate income.
Pursuant to Internal Revenue Code § 1361, there are certain requirements that a business entity must satisfy to qualify for S-corporation status:
- It must be a domestic corporation;
- Shareholders must generally be individuals, although estates and certain trusts and organizations may be shareholders;
- There cannot be more than 100 shareholders;
- There must only be one class of stock;
- It may not be an ineligible corporation (such as certain financial institutions, insurance companies and domestic international sales corporations); and
- Nonresident aliens may not be shareholders.
The election for an S-corporation may be revoked in two ways: (1) voluntarily by more than 50% of the shareholders; or (2) involuntarily if an event occurs where an S-corporation no longer qualifies due to one of the restrictions above; in which case, the termination of the S-corporation status occurs at the time of the event.
One particular issue for business entities hoping to maintain S-corporation status is the community property laws in place in some jurisdictions. If a U.S. citizen owns an S-corporation and marries a nonresident alien in a jurisdiction with community property laws, where the couple’s property is deemed as community property, the nonresident alien will become a shareholder of the S-corporation by operation of law and thereby terminate the S-corporation election. Even a prenuptial agreement cannot prevent the termination of the S-corporation election. In Ward v. U.S, the Court dealt with a prenuptial agreement of a U.S. citizen and his spouse in a jurisdiction with community property laws. 661 F.2d 226 (Fed. Cir. 1981). The prenuptial agreement stated that certain property remained the sole ownership of the U.S. citizen, including shares in an S-corporation. The court determined that the prenuptial agreement was unenforceable and the S-corporation election was still terminated.