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An S corporation is not a legal business form. Rather, it is a tax status the Internal Revenue Service confers on an existing corporation. A regular corporation pays corporate income tax, and then shareholders pay individual income tax on their distributions. With an S corporation, the company's earnings are not taxed; instead, they are "passed through" to the shareholders for taxation. To receive this favorable tax treatment, S corporations must comply with specific guidelines. As a general rule, an S corporation may own stock in another corporation, but such ownership may have consequences for the shareholders and the second corporation.
General Requirements for S Corporations
The business must be incorporated domestically, that is, it cannot be a foreign corporation. There may be no more than one stock class, and the number of shareholders may not exceed 100. Shareholders must be individuals, estates or qualified trusts. Non-resident aliens, corporations and partnerships are not acceptable shareholders in an S corporation.
S Corporation Owning Stock in an S Corporation
It is not accurate to state that an S corporation cannot own stock in another S corporation. It is possible, but it would violate the rules. This means that the company selling the stock to another S corporation would lose its status as an S corporation. The IRS would then tax the second company as a regular corporation, resulting in "double taxation" and higher taxes for the shareholders.
S Corporation Owning Stock in a C Corporation
An S corporation does not jeopardize its tax status if it purchases stock in a C corporation. If the S corporation shareholders are not active, material participants in the C corporation, dividends and profits from the sale of the C corporation's stock are typically subject to the passive-income limits. These limits apply to each individual shareholder, who must determine whether they "materially participated" in the C corporation's activities. The limitations on passive income do not apply to the S corporation.
S Corporation Owning Stock in an LLC
A limited liability company, or LLC, is a type of business entity that offers many of the benefits of a corporation, such as protecting shareholders from liability, with the "pass-through" taxation of a partnership. An S corporation may own stock in an LLC. However, some LLCs elect S corporation tax status. Selling stock to another S corporation may jeopardize the LLC's tax status with the IRS.