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More than 3,000,000 businesses operate as Subchapter S corporations. But that's not really a surprise if you understand a bit about tax law. An S corporation doesn't pay corporate income taxes, which can take as much as a fifty percent whack out of profits. What's more, an S corporation typically reduces Social Security and Medicare taxes paid on behalf of shareholder-employees by several thousand dollars a year per shareholder-employee.

That's good news if you're a small business owner. But there's bad news, too, when you start talking about S corporations. You need to meet a number of qualifications in order to be treated as an S corporation, as outlined in the following paragraphs.

S Corporations Must Be Domestic U.S. Corporations

The first qualification is that only U.S. domestic corporations are eligible to become S corporations. A domestic corporation is one formed according to the laws of one of the states (for example, California) and not a foreign corporation formed in, say, Japan or France.

S Corporations Can Have Only a Limited Number of Shareholders

A second S corporation qualification relates to the number of shareholders. In order to be treated as an S corporation, the business must have 100 or fewer shareholders.

You do have a bit of wriggle room in this "100 or fewer" test, however. A family group typically counts as a single shareholder. A family includes a parent, his or her children, grandchildren, great-grand children and so on through the great, great, great grandchildren. Also, a husband and wife who both own S corporation stock count as a single shareholder.

S Corporation Shareholders Must Be U.S. Citizens or Permanent Residents

Another shareholder qualification exists for S corporations, too. In general, the owners, or shareholders, of an S corporation can be only individuals who are U.S. citizens or permanent residents. In other words, you can't use the S corporation option if one of your shareholders is non-US taxpayer.

Note, however, that a handful of special exceptions to the rule about "individual U.S. taxpayers" exist. A U.S. taxpayer's estate after he or she passes away and a U.S. testamentary trusts (created by a will) can sometimes be S corp stockholders. So can a U.S. taxpayer's bankruptcy estate. Also, in some special circumstances, a charity can also own S corporation stock and so can another S corporation.

And, just to make this point, while S corporations can own shares in partnerships or regular corporations, partnerships and regular corporations can't own shares in an S corporation.

S Corporations Can Have Only One Class of Stock

Another qualification for becoming an S corporation is that the corporation can have only a single class of stock. The single-class-of-stock requirement can get tricky, but what it really means is that profits or losses--both those that occur over the time the corporation operates and those that occur when the corporation liquidates--must be distributed based on the ownership percentage.

If a shareholder owns 10% of an S corporation, for example, he or she should get 10% of the operating profit each year and 10% of any distributions of that profit. Similarly, when an S corporation dissolves, any profit and distributions paid at dissolution must be calculated using shareholder percentages.

Note that an S corporation can have nonvoting stock because not being able to vote doesn't affect a shareholder's shares of profit, loss and distribution. Also, an S corporation can pay different employees (including shareholder-employees) different salaries.

S Corporations Can't Appear on the Prohibited S Corporation List

One final qualification to being an S corporation needs to be mentioned. Some types of corporations are prohibited by law from operating as S corporations. The list includes Subchapter L insurance companies, banks and other financial institutions using the "Sec. 585 reserve method" for dealing with bad debts, domestic internal sales corporations, and (finally) a corporation that's taken the Puerto Rico and possessions tax credit for doing business in a U.S. possession.

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Stephen L. Nelson,CPA, publishes the do-it-yourself S corporation and incorporation web sites and occasionally teaches limited liability compan and S corporation tax law to CPAs and attorneys at Golden Gate University's graduate tax school

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