At first glance, S Corporations offer compelling benefits for small business owners, i.e., limited liability, simplified taxation, and potential access to certain loss deductions under the Internal Revenue Code. However, a lesser-known but critical rule can threaten these benefits: S Corporations cannot have foreign shareholders. This rule is absolute, and even one mistake can trigger termination of the S election, resulting in double taxation and potential IRS scrutiny.
Who Can Own Stock in an S Corporation?
Under 26 U.S. Code § 1361(b)(1)(B), S Corporations may only have certain types of shareholders:
- U.S. citizens
- U.S. resident aliens (as defined by IRS tax residency rules)
- Certain domestic trusts (e.g., QSSTs and ESBTs)
- Estates
- Certain qualified 501(c)(3) organizations
Nonresident aliens, defined as individuals who do not meet the substantial presence test or hold a green card, are strictly prohibited. If a nonresident alien directly or indirectly becomes a shareholder, the S Corporation status is automatically terminated, and the business becomes a C Corporation, subject to double taxation.
A Common Mistake: Foreign Family Members or Silent Investors
It is not uncommon for business owners to offer shares to close friends, spouses, or family members. Sometimes they may even reside outside the United States. This often occurs informally and with good intentions, but the IRS does not allow for informal exceptions. Even if the foreign shareholder holds only a single share, the result is the immediate termination of S status.
In our experience at Twisdale Law, PC, this often happens when:
- A family member abroad is added as a co-owner
- A spouse who is not a U.S. citizen holds a community property interest in the shares
- Ownership is transferred through inheritance without checking the tax status of the heirs
Community Property and Foreign Spouses: A Trap for the Unwary
A particularly dangerous pitfall involves community property laws, which apply in states like Texas, California, and Arizona. While these laws do not apply in North Carolina, South Carolina, or Tennessee, some clients may have ownership interest in these states. If a shareholder lives in or moves to one of those states, a spouse may automatically obtain a beneficial ownership interest in the S Corporation stock, even without a formal transfer.
This issue was central in Ward v. United States, 661 F.2d 226 (Ct. Cl. 1981). In that case, a U.S. citizen owned S Corporation stock, but his spouse, who was a citizen and resident of Mexico, held a community property interest. Despite being passive and not directly involved in the company, her ineligible foreign status caused termination of the corporation’s S election.
Even the family shareholder aggregation rule under the American Jobs Creation Act of 2004 (AJCA), which allows family members to be counted as one shareholder under § 1361(c)(1), does not cure this issue. The spouse was still ineligible under federal tax law, and the community property interest disqualified the corporation.
The takeaway is clear. Ownership rights matter, even if the foreign spouse is not listed on the company’s records.
Preventing Inadvertent Termination
To avoid costly errors and IRS penalties, S Corporation owners should take the following precautions:
- Verify the citizenship and residency status of all owners and spouses
- Review trust agreements carefully before transferring stock
- Restrict the transfer of shares using shareholder agreements
- Avoid gifting or inheriting shares without a legal review
- Understand the implications of community property rules when operating in or moving to certain states
What to Do If Foreign Investment Is Necessary
Anticipate needing foreign investment or have foreign family members involved in ownership planning? An S Corporation may not be the right entity for your business. In these cases, a C Corporation or multi-member LLC may offer more flexibility while still providing limited liability and access to outside capital.
Twisdale Law, PC regularly counsels clients on these transitions and can help assess tax and governance tradeoffs before you make a decision.
Twisdale Law, PC: Helping You Avoid S Corporation Pitfalls
Serving clients across North Carolina, South Carolina, and Tennessee, Twisdale Law, PC provides counsel on all aspects of S Corporation compliance, formation, and restructuring. Our firm helps business owners:
- Maintain S Corporation eligibility
- Resolve shareholder disputes
- Structure ownership in compliance with federal tax law
- Transition to other entity types when business goals shift
Whether you are planning an S Corporation election, managing a trust as a shareholder, or preparing to onboard new investors, we can guide you through the complexities and prevent avoidable legal risks.
If you are unsure whether your current or future shareholders are eligible under Subchapter S, or if you are concerned about foreign ownership or community property exposure, do not wait until it is too late.
Contact Twisdale Law, PC today to schedule a consultation and ensure your business stays compliant and protected.
