Shareholder Limits: Staying Private While Growing Your Business

For decades, private companies have had to navigate shareholder restrictions with different corporate structures. While C corporations face no limits, S corporations have long faced shareholder limits to maintain their flow-through tax status. The Internal Revenue Code places a 100 shareholder limit on S corps as one requirement to elect S corporation status. Exceeding this limit can lead a company to lose its S election and be taxed as a C corporation. With only one class of stock permitted, complex share structures are prohibited.

For larger private companies, the Securities and Exchange Commission (SEC) also imposes a 2,000 shareholder limit to avoid public reporting. Companies must track total shareholders and beneficial owners holding stock options. Navigating these limits is crucial as companies grow and raise capital. This guide will examine the intricacies around shareholder limits, reporting requirements, strategies to stay compliant, and how the rules differ from C corporations.

The 100 Shareholder Limit

The tax laws limit S corporations to having a maximum of 100 shareholders, a change from the previous restriction of 500 shareholders in the late 1990s. This limit was set in 1958 when the tax law for Subchapter S status was first introduced. The goal was to reserve this tax option for businesses and prevent larger companies from benefiting from pass-through taxation. Over time, as S corporations gained popularity, it became evident that the 500 shareholder cap was too restrictive.

Small and mid-sized businesses faced challenges obtaining S corporation status because of the shareholder limit. The Small Business Job Protection Act of 1996 raised the full corporation shareholders limit to 75. Subsequently, the American Jobs Creation Act of 2004 completely removed the cap allowing up to 100 shareholders for an S corporation. This restriction on having 100 shareholders serves to uphold the goal of Subchapter S, enabling family-owned enterprises to evade dual taxation.

The limit prevents larger enterprises with many individual investors, from electing S status, ensuring this tax structure is reserved for closely held companies as intended. Any corporation with over 100 shareholders must operate as a standard C corporation subject to corporate income taxes.

Counting Shareholders

The exact number of shareholders a company has can be complicated to determine. Here are some key rules around counting shareholders:

• Only living individuals are counted as shareholders. Entities like trusts, partnerships, and estates are not included in the count.
• A husband and wife count as one shareholder, regardless of how the stock is titled. All other family members count as separate shareholders.
• Beneficial owners of shares, not just legal owners, are counted toward the limit. For shares held in brokerage accounts, the underlying beneficial owner is the shareholder for limit purposes.
• A shareholder is counted as anyone who owns shares for any part of a day during the tax year. The number is calculated based on the maximum number of shareholders during the year.
• Attribution rules "look through" partnerships, trusts, and estates to the underlying beneficial owners of the S corp shares. These indirect shareholders must be counted toward the limit.
• Ineligible shareholders, such as nonresident aliens and partnerships, can own S corp stock but do not count toward the shareholder limit. However, any eligible shareholders behind an ineligible shareholder are counted.
• Joint ownership of shares counts as one shareholder. Tenants in common are treated as separate shareholders. Proper shareholder counting is essential to avoid exceeding the 100 limit inadvertently. Companies must track stock transfers and indirect share ownership closely. Consulting a tax advisor can ensure the shareholder count is determined correctly.

Consequences of Exceeding the 100 Shareholder Limit

Going beyond the threshold of 100 shareholders can significantly impact an S corporation's standing and tax handling. Should an S corp surpass the shareholder limit at any time within a tax year, its S corporation designation is automatically revoked for that fiscal year. Consequently, the firm promptly transitions into a C corporation if it exceeds the shareholder cap.  Several tax consequences occur when exceeding the limit causes an S corp to switch to C corp status:

• The corporation will be subject to double taxation. Income is taxed first at the corporate level and again when distributed to shareholders. S corporations only face a single income taxation.
• Net operating losses are suspended. Existing S corp losses can't offset C corp income. The suspended losses can only be used if the company makes a new S election in the future.
• Assets may need to be written up or down. If their market value differs from a tax basis, they may need to be revalued.
• LIFO recapture taxes may apply. C corps using LIFO inventory accounting may face added taxes.
• Built-in gains are recognized. Any gains before the termination of S status are taxed over the next 10 years. Transitioning back to S corp status involves making a new S election.

There are restrictions around determining how soon a company can re-elect after revoking or terminating S corporation status. Careful planning is required to avoid missteps when exceeding the 100 shareholder limit, jeopardizing S corp status.

The 2,000 Investor Limit

S Corporations would face another restriction if their shareholder count exceeds 2000. This limitation stems from Section 12(g) of the Securities Exchange Act of 1934, which mandates private firms with over 2,000 recorded shareholders register their securities and provide disclosures similar to public enterprises. Once an S corporation surpasses the 2,000 shareholder mark, it must register with the SEC and file quarterly reports. This places the company under filing governance and compliance regulations like those governing traded companies.

The administrative costs of compliance alone can be a significant burden for a private S corp. Additionally, with registration comes increased transparency and public scrutiny, which many private company owners wish to avoid. As such, crossing the 2,000 investor threshold typically signals the end of an S corp's run and forces transitions to either C corp status, going public, or exploring other options.

Private companies must carefully monitor their shareholder count in annual reports and beneficial ownership reports to avoid accidentally exceeding the 2,000 investor limit. Putting proper transfer restriction agreements in place is crucial. Companies also need clear plans to transition their legal structure if they approach the threshold.

Reporting Requirements for S Corporations

S corporations must fulfill certain reporting requirements once they near or exceed the 100-shareholder limit. These reporting rules increase transparency for regulators and investors.

Beneficial Ownership Reports

S corporations that have over 100 shareholders are required to submit a report on ownership to the IRS. This report reveals any shareholders who own more than 5% of the company's stock. Beneficial ownership of corporation stock indicates that an individual can vote or invest in the shares even if they do not directly own the stock in their name. These IRS submissions must be finalized within 60 days after the conclusion of the company year. The reports offer regulators and minority shareholders insights into those who control portions of the company.

Insider Transaction Reports

In addition to IRS reporting, once an S corp surpasses $10 million in assets and 500 shareholders, it triggers SEC rules. The company's officers, directors, and 10% shareholders must file ownership reports upon becoming insiders. They must also report any transactions and compensation on an ongoing basis. These forms disclose potential conflicts of interest to other shareholders.

Strict regulations govern loans and other deals between insiders and the company. Violating these SEC rules results in heavy penalties. Staying aware of all reporting deadlines is crucial for maintaining compliance as a private S corporation grows its shareholder base. Some relief is provided when calculating the shareholder limit, for example, but meeting these transparency requirements is mandatory once it is exceeded.

Maintaining Compliance

Staying within the shareholder limits requires proactive steps by company leadership and management. Failing to monitor and control share ownership properly could lead to loss of S corporation status. Here are some best practices for maintaining compliance:

Tracking shareholders and share transfers - Companies should closely track stock purchases and sales to avoid exceeding 100 shareholders. A share transfer ledger should be maintained and reviewed regularly. Legal counsel should review any proposed share transfers that could impact compliance.

Amending governing documents - The company's bylaws, shareholder agreements, and other documents should contain provisions restricting share transfers that could cause a loss of S status. Amendments may be needed to reduce the chances of non-compliance.

Staying informed on regulatory changes - Laws and regulations related to S corps evolve. Leadership should regularly consult legal counsel and tax professionals to stay up-to-date on changes affecting shareholder limits, beneficial ownership, and other compliance issues. Proactively adapting to new rules is key.

Conducting periodic compliance reviews - Companies should perform periodic reviews to verify compliance with shareholder limit rules and beneficial ownership reporting requirements. Confirming all filings, submissions, and charter documents helps avoid issues.

Providing investor education - Educate shareholders on the law and the implications of transferring shares to ineligible holders. Require notice before share transfers to avoid surprises. Ensure appropriate legal provisions are in shareholder agreements.

Diligent compliance practices enable companies to focus on business operations with the assurance they will retain S corporation status. Consulting professionals and establishing solid tracking procedures are worth the investment.

Transition Planning

Companies must start planning for the future as they approach the shareholder limits. Having a strategy in place can help smooth transitions when growth pushes past legal thresholds. Here are some key considerations:

• Preparing for Growth Beyond Limits While companies may aim to stay private as long as possible, fast growth can quickly make shareholder caps unrealistic. Develop projections of increased investors and stockholders to see when your company may exceed limits. This analysis gives you a runway to make any structural changes in advance. You can also model different fundraising scenarios to optimize timing and sources of capital.
• Considering an IPO or Acquisition Once they are nearing 2,000 investors, going public via an IPO becomes an option for additional growth. This path takes substantial preparation but opens access to public capital markets. Other liquidity solutions like mergers, acquisitions, or private equity investments can also be explored. After years of building value, these allow owners and employees to take money off the table.
• Weighing the Benefits and Costs An IPO or acquisition can accelerate the company’s growth, but it also comes with tradeoffs. Public reporting requirements are extensive. Giving up control and absolute decision-making needs to be evaluated. Companies should involve legal and financial advisors early on to map out the pros and cons of different options. This ensures you pick the optimal path when shareholder limits necessitate a change.
• Creating Transition Plans Don't wait until you blow past limits and face penalties or emergency restructuring. Proactively plan for changes through scenario analysis. Evaluate options, model timelines, and draft contingency blueprints. Engage your Board and management team in the process. With thoughtful preparation, you can transition smoothly while achieving the best outcome for shareholders and the company's future.

Differences from C Corps

S corporations have rules and restrictions compared to C corporations regarding shareholders and taxes. Here are some of the key differences:

• Shareholder Limits - S corps cannot have more than 100 shareholders, while C corps has no limit on shareholders. Also, S corps can only have one class of stock, while C corps can have multiple classes.
• Ownership Structures - S corps cannot have non-resident alien shareholders, while C corporations can. Other corporations and certain trusts cannot own shares in an S corp, while C corps have no restrictions on ownership.
• Pass-Through Taxation - S corps are pass-through entities, so profit/loss is passed directly to shareholders' personal tax returns. C corps are taxed at the corporate level, and shareholders pay taxes on dividends.
• Operational Requirements - S corps can only issue common stock, while C corps can issue preferred stock. S corps also have restrictions on deducting operating losses.
• Reporting Requirements - S corps have reduced reporting requirements compared to public C corps but must still file annual tax returns. Private C corps have the least reporting requirements.
• State Taxes - Some states tax S corps differently than C corps. S corps may pay lower state income taxes in certain states.
• Reorganizations/Mergers - S corps cannot participate in certain mergers without losing the S corporation status that C corps can undertake. So, S corps operate under stricter shareholder, ownership, and operational rules, given their special tax treatment as pass-through entities. C corps have more reporting requirements but more flexibility for growth.

Conclusion

Shareholder limits are a key consideration for S corporations and private companies looking to grow while maintaining their structure. As we've covered, the primary thresholds to be aware of are the 100 shareholder limit for S corps and the 2,000 shareholder limit for staying private under SEC rules. Exceeding these limits can lead to significant consequences, like automatically converting to a C corporation or needing to take on public company reporting requirements. It's critical that companies closely monitor their shareholder counts and ownership structures to avoid accidentally triggering these thresholds. Some key strategies include:

• Tracking beneficial ownership to count shareholders accurately
• Developing a transition plan if approaching a limit
• Exploring restructuring options like forming an umbrella partnership corporation

The rules around S corporation shareholder limits are complex but essential to understand. With careful planning and compliance, companies can use S corp status to gain tax advantages and raise investment capital while remaining private entities. Consulting with legal and tax advisors is highly recommended when deciding shareholder counts and distributions.

Staying below the shareholder limits requires diligence, but it enables businesses to operate with the benefits of a corporation while being exempt from many public company burdens. Careful tracking of the shareholder's stock basis, owner roster, and ownership percentages is needed to maintain compliance. However, the flexibility and tax perks accessible make navigating these limits worthwhile for private companies looking to thrive.

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