S Corporations and Stock Ownership Issues

The Small Business Job Protection Act of 1996 and its amendments in 1997 eased some of the stock restrictions surrounding S corporations. The amended law also added significant tax-saving provisions for S corporations and provided a number of important benefits for shareholders and employees.

Tax Benefits
Before the passage of the Small Business Job Protection Act, only individuals or other taxable entities could own stock in S corporations, and all corporate profits were subject to taxes. However, the amended law now allows a nontaxable Employee Stock Ownership Plan (ESOP) to hold stock in an S corporation, giving shareholders a way to defer some of their taxes.

Simply put, if you set up an ESOP for an S corporation and it owns 40 percent of your company’s stock, then 40 percent of your earnings are untaxed. Employees don't pay taxes on their ESOP holdings until they make a withdrawal from the plan, such as when they retire or leave the company.

Shareholder Specifics
Pay careful attention to how employees make withdrawals from an ESOP. It is illegal for employees to transfer S corporation stock directly into an IRA, and allowing them to do so could jeopardize your corporation's legal status. You may choose to require departing employees to take ESOP distributions in cash instead of in stock.

The Act also increased the number of individuals who can hold stock in an S corporation from 35 to 75, and S corporations are allowed to issue only one class of stock. Because the Internal Revenue Code restricts who can hold S corporation stock, make sure shareholders don't transfer their shares to ineligible entities, such as partnerships, C corporations, nonresident aliens, limited liability companies, or foreign trusts. Eligible shareholders include:

• Citizens or resident aliens of the United States
• Estates
• Certain trusts, such as pension trusts
• Charitable organizations
• Employee stock ownership plans

Even though you can issue stock, you probably won’t have to worry about registering with the U.S. Securities and Exchange Commission (SEC). To find out if your business does need to register, visit the SEC Web site.