Unmasking the Myths: Who Can Truly Be a Shareholder in an S Corporation?

Revisiting the Basics of the S Corporation: Nonresidents as Shareholders
Small business corporations are more popular than ever. You hear about them on social media, and among the tax community. Indeed, small corporations (commonly referred to as S corporations or S corps) are one of the most accessible tax vehicles for entrepreneurs to reduce their tax burden. The main benefit of the S corp is without a doubt, prevention of the double taxation that occurs at traditional C corporations (C corps) (taxed at the corporate level and then taxed at the shareholder level).

Although the S corp is very favorable in terms of its taxation, we must remember that the requirements to qualify as an S corp are traditionally seen as very restrictive. In this article, we will revisit one of the requirements for an S corp: Who can be a shareholder of an S corp?

Some generalized perspective is that only United States (US) residents can be shareholders of an S corp. And by “residents” such perspective is that it refers to people with Social Security numbers (SSNs) (excluding individuals with individual taxpayer identification numbers (ITINs)). This article reflects on some of these myths: (i) by establishing who can qualify as a shareholder in an S corp, (ii) defining whether an individual with an ITIN can be a shareholder of the S corp, (iii) analyzing and establishing some scenarios in which a nonresident could be
an indirect shareholder of the S corp, and (iv) cases where a nonresident can actually be a direct shareholder of the S corp.

S Corporation Requirements
To qualify as an S corp, an entity must be a domestic corporation, have no more than 100 shareholders, not have a nonresident alien as a shareholder, and have only one class of stock.ⁱ In this article, we will focus on the analysis of who can be a shareholder of the S corp, and determine if a nonresident really is prevented from being a shareholder in these types of entities.

Who Can Be a Shareholder of an S Corporation?
A corporation may only elect S corp status if it has no more than 100 shareholders.ⁱⁱ Furthermore, the Internal Revenue Code (IRC or the Code) specifies that particular types of entities, including partnerships, corporations, and nonresident aliens, are ineligible to hold shares in an S corp.

Only individuals, certain trusts, and estates are eligible to be shareholders. Nonresident aliens are precluded from holding stock in an S corp. Apparently, this results in that only US citizens and residents are allowed to be shareholders of an S corp.ⁱⁱⁱ Our analysis will focus on these two categories first, and then we will proceed to discuss the nonresident category.

United States Citizens
In the context of US tax law, the term “US citizen” is a pivotal designation that directly impacts tax obligations, including the determination of who is subject to worldwide taxation by the Internal Revenue Service (IRS) and the eligibility criteria for specific tax elections, such as
S corp status.

A “US citizen” encompasses any individual who has obtained United States citizenship by virtue of birth or naturalization.^iv This means that any individual born within the United States or in select US territories (such as Puerto Rico, Guam, or the US Virgin Islands) is automatically deemed a US citizen.^v Furthermore, an individual may also become a US citizen through the process of naturalization.^vi This occurs after the individual has met the necessary residency, language, and legal requirements.

In the context of taxation, a US citizen is liable for federal income tax on his or her worldwide income.^vii This obligation extends irrespective of the individual’s place of residence. Additional reporting obligations are imposed on any foreign holdings, such as interest in a controlled
foreign corporation (CFC), or foreign bank accounts.

Additionally, US tax law acknowledges individuals who possess dual citizenship. A dual citizen who holds US citizenship is nevertheless subject to US tax laws.

Residents
In the context of US tax law, the term “resident” refers to individuals who qualify as resident aliens in accordance with the provisions set forth in the Code. Resident aliens are typically liable for US taxation on their global income, similar to that of US citizens. To determine
whether a foreign national is classified as a resident alien or a nonresident alien, the IRS employs two principal tests: the green card test and the substantial presence test. There is an additional avenue to be classified as a resident, which is if the nonresident elects to be treated as a resident for the first year (so called first-year election).

i.Green Card Test
The green card test is a criterion used to determine whether an individual is classified as a resident alien or a nonresident alien. In accordance with this test, a foreign national is deemed a resident if he or she is granted lawful permanent resident status (i.e., possess a green card) at any point during the calendar year.^viii
ii. Substantial Presence Test
The substantial presence test represents the principal avenue for determining whether an individual who is not in possession of a green card can still be classified as a US resident for tax purposes. The test is based on the number of days the individual is physically present in the United States over the course of a three-year period.

To qualify as a resident under the substantial presence test, the individual must satisfy two conditions:

• A minimum of 31 days of presence in the current year is required. The individual must have been physically present in the United States for a minimum of 31 days during the current calendar year.^ix
• A total of 183 days of presence is required. The 183 days are the total result of the days accumulated during the current year and the immediate two preceding years.^x This is calculated using the following formula:
  – All days within the current year are to be counted in their entirety.
  – One-third (1/3) of the days from the previous year are included in the calculation.
  – One-sixth (1/6) of the days from the second preceding year are counted.

For example: If a Japanese citizen (not US born) was physically present in the United States for 120 days in each of the three most recent years (2024, 2023, 2022), the calculation would be as follows:

In the current year (2024), the Japanese individual would count 120 days. For 2023, however, the Japanese individual would count only 40 days (one-third of 120 days) toward the substantial presence test. For 2022, only 20 days are counted (one-sixth of 120 days). The total amount of days would be 120+40+20 which equals 180 days thus failing to meet the threshold of 183 days required to be classified as a resident for tax purposes.

In either of these two cases, green card holder or individual meeting the substantial presence test, there should not be a question about his or her eligibility to be shareholders of an S corp, because they are residents under the Code. However, this seems to not be the case, in accordance with traditional knowledge held by some in the tax community. We proceed to discuss these myths and offer additional examples to support our statement that even nonresidents can be shareholders of an S corp.

Various Problems with the Shareholders Requirement
Generally, a tax professional may not be concerned about who can qualify as a shareholder of the S corp, under the above-described rules. However, there may be some cases where the tax professional may encounter some challenges when setting up the S corp. One of those frequent challenges is when the individual presents an ITIN rather than a Social Security number (SSN). In those cases, apparently, there is an established understanding (we call it “myth”) among tax professionals to disqualify such individual from the benefit of the S corp. This traditional perspective could not be more wrong, as we will establish.

The IRC provides that an S corp cannot “have a nonresident alien as shareholder.”^xi  For the traditional view, this is enough to argue that only individuals that are legally in the United States or that qualify for an SSN could be shareholders of an S corp. Let us continue with the analysis to prove this view as incorrect.

United States Treasury Department (Treasury) regulations repeat the verbiage of the statute by stating that an S corp means a domestic corporation that does not have “(iii) a nonresident alien as shareholder.”^xii

However, if we continue the reading of the regulations, we will find more information about the definition of a “nonresident alien.” Treasury Regulation (Treas. Reg.) 1.1361-1(g)(1)(i) clearly states that “a corporation having a shareholder who is a nonresident alien as defined in section 7701(b)(1)(B) does not qualify as a small business corporation.” According to such section, the term “nonresident alien” is defined as provided in §7701.

Section 7701(b)(1)(B) establishes the different categories of individuals or entities that qualify as a resident or nonresident for tax purposes.

As described in the previous section, an individual is categorized as a resident alien if: (i) the individual holds permanent residence in the US (the so-called green card test); (ii) if the individual is physically present in the US for 183 days or more within the last 3 years (the so-called substantial presence test), and (iii) the individual, a nonresident, makes an election to be treated as resident for first year of presence in the United States.

Any individual that does not fall within one of these categories is considered to be a nonresident for purposes of the IRC.

Reading back to the S corp provisions, this means that for an individual to be a shareholder of an S corp, such individual would need to fall within one of the three categories listed above: (i) be a green card holder, (ii) meet the substantial presence test, or (iii) make the first-year election.

The first category does not present any practical issue, because the green card holder would generally have an SSN available. However, we find that the traditional view is that an individual with an ITIN living in the United States could not qualify for the S corp. If such individual meets the requirements of the substantial presence test, such individual will also qualify as a shareholder of an S corp. The ITIN requirement has nothing to do with the requirements of the statute to be a shareholder of the S corp.

Individuals with ITINs living in the United States are residents for tax purposes. This means that they are allowed to be shareholders of an S corp. Why is this? Because they meet the substantial presence test, which results in residency for tax purposes.

As previously described, an individual meets the substantial presence test if such person meets two requirements. First, such individual must be physically present in the United States for 31 days in the current year. Second, the individual must be physically present in the United States for 183 days or more within the last three years, including the current year.^xiii For example, an individual from France who is physically present in 2023 for 190 days will be classified as a tax resident under the substantial presence test. That French individual could be a shareholder of an S corp, despite not having an SSN.

Other scenarios come to mind as well. For example, individuals who frequently travel to the United States and who meet the 183 days within a three-year period, would also be treated as a tax resident, even if they only hold a tourist visa. A more frequent scenario includes individuals who are physically present in the United States and who do not qualify for an SSN, for whatever reason. Those individuals would also be classified as a tax resident for U.S. tax purposes. Therefore, they would be deemed as proper shareholders of an S corp.

As seen from the previous scenarios, the “tax residency” denomination has nothing to do with the “residency” for immigration purposes. Moreover, a “resident” for purposes of an S corp has nothing to do with having or not having an SSN.

This circumstance has been properly recognized by the IRS itself. In its manual, the IRS clearly states that “ITIN holders are eligible to be a shareholder of a Subchapter S corporation.”^xiv

Under the above provisions, we can clearly conclude that from a tax perspective, a resident includes any individual that meets the substantial presence test, despite his or her respective immigration status or not having an SSN.

Other Legal Implications
Is the individual without proper working authorization prevented from being a shareholder/employee in the S corp due to his immigration status?

A tax professional “should provide clients with the highest quality representation concerning federal tax issues.”^xv Some tax professionals are concerned that advising taxpayers on their eligibility to be shareholders will likely result in criminal conduct.

This issue arises in the context of the shareholder of an S corporation who also is an employee of such entity. If the ITIN holder (who generally tends to be a sole or majority owner) is an officer of the corporation, such individual is automatically deemed as an employee. ^xvi As employees, they should receive reasonable compensation. Allegedly, some argue that the fact that they receive reasonable compensation from the S corp without the proper authorization would result in a violation of the immigration laws. Consequently, those individuals are advised that they do not qualify to be a shareholder in the S corp. These individuals will hold an ITIN instead of an SSN.

A first approach to this argument is that this is not a tax issue, but rather a consequence for other titles of the US Code. Whether a tax professional (such as an enrolled agent (EA) or a certified public accountant (CPA)) should advise on the legal implications for immigration
purposes deriving from the receipt of reasonable compensation with an ITIN would definitely constitute legal advice, which is prohibited unless the professional is a licensed attorney.

A second approach is to answer the question as to whether the individual is actually deemed to be an employee working in the United States without proper authorization. If such is true, then, indeed, the officer/shareholder with an ITIN (and no proper immigration status) would commit a conduct that would result in some illegal conduct.

In such regard, the author (a licensed attorney) refers to the respective immigration case law related to employment, issued by the Office of the Chief Administrative Hearing Officer (OCAHO). The OCAHO supervises the administrative law judges that interpret and apply the related employment immigration provisions of the Immigration Reform and Control Act of 1986 and Immigration Act of 1990.

The OCAHO case law has recognized that “an individual is not an employee of an enterprise if he or she has an ownership interest in, and control over, all or part of the enterprise.”^xvii This would mean that a sole owner of an S corp, who is also an officer of such entity, and who receives compensation, would not be classified as an employee for immigration purposes, if such individual has control over all or part of the S corp. This conclusion would allow the shareholder with an ITIN to clearly be a shareholder for immigration purposes, without incurring any illicit conduct.

A variety of factors are analyzed to establish whether an owner is not classified as an employee of an enterprise. For example, if the worker does not report to a supervisor, or if the worker can influence the business’s general operations and strategic direction. If the worker shares in the business profits and losses, or if the worker cannot be easily fired by the business, are also factors used to establish that an owner/employee is actually an owner.

In the common scenario, for example, an individual with an ITIN, due to his or her lack of proper immigration status, and owner of an S corp, would be deemed as an owner, not an employee of his or her S corp, if such individual controls the S corp, and is the sole employee of the entity.

Under the previous analysis, we conclude that an individual that meets the substantial presence test, even with an ITIN, definitely qualifies to be a shareholder in an S corp. Even from an immigration perspective, there seems to be legal support that no illicit conduct will result from the fact that the individual receives reasonable compensation from the S corp.

This analysis is helpful to clarify the longstanding myth that individuals with an ITIN are automatically disqualified from being shareholders of an S corp, because they are “nonresidents,” when in reality, they are “residents” for tax purposes.

As we will see in the following sections, there are real cases where actual nonresidents could be shareholders of an S corp due to an amendment and a flaw in the Code.

Cases Where a Nonresident Can Be a Shareholder of the S Corporation Electing Small Business Trust with a Nonresident as a Potential Current Beneficiary

In this scenario, different from the previous one, we will discuss a case where a nonresident can hold S corp stock indirectly.

Certain trusts can be shareholder of an S corp. For example, a trust whose owner is a citizen or resident of the United States.^xviii Another type of trust that is allowed to be shareholder of the S corp is the so-called electing small business trust (ESBT).^xix

An ESBT is a type of trust that can hold stock in an S corp. The main benefit of the ESBT is that it allows multiple beneficiaries. The disadvantage is that the portion of the ESBT that consists of stock in one or more S corporations is treated as a separate trust.^xx The income of this portion of the ESBT is taxed at the highest rate applicable to trusts.^xxi

One would ask why someone would hold S corp stock in an ESBT. The reasons can be varied, but one common scenario is as follows: Imagine John, a founder of an S corp, who has several children. As part of his estate plan, John sets up a revocable living trust, for the benefit of his spouse and his two kids. He then contributes his interest in the S corp to the trust. Upon his death, the trust becomes irrevocable and continues to hold the S corp stock.

From a tax perspective, during the life of John, the trust will be treated as a grantor trust because John has a reversionary interest in the trust during his life (i.e., He can revoke the trust during his life).^xxii Upon death, the trust would become irrevocable and if it continues to exist after John’s death, such trust could hold the S corp stock for a maximum of two years.^xxiii After such period, the trust would be prevented from holding S corp stock, unless the trust elects to be treated as a trust allowed to hold S corp stock. For example, the trust could make an election to be treated as an ESBT, especially considering that such trust allows to have multiple beneficiaries.

The problem with the ESBT is that before the Tax Cuts and Jobs Act (TCJA), the potential beneficiaries of the ESBT (in this case, the spouse and the kids) would need to be residents or US citizens. This could trigger multiple problems if there happened to be a nonresident as a potential beneficiary.

However, after the TCJA, an ESBT can have a nonresident as a potential beneficiary.^xxiv This means that nonresidents can be potential beneficiaries of an ESBT. In other words, a nonresident could hold S corp stock indirectly via the ESBT.

Nonresident Applying Tax Treaty Benefits
The previous section discussed a case where a nonresident could be the indirect shareholder of an S corp. However, in this last section, we will discuss the incredible case where a nonresident can actually be the direct shareholder of an S corp.

In this scenario, there is a clear intersection of the international tax and the S corp rules, which rarely occurs in the Code. Other sections that relate to this intersection may be, for example, the applicability of anti-deferral regimes such as the application of global intangible low-taxed income (GILTI), among others.

As previously discussed, an individual can qualify as a tax resident under either of three tests. One must remember that the fact that an individual is a resident of the United States does not prevent such person from being a tax resident of another jurisdiction. These cases are more frequent than ever. For example, students that move to the United States, individuals moving to the US or even US individuals who move abroad.

In all these cases, the individuals would have to consider two sets of rules: one for the United States and another, for the other country. A real scenario is helpful to understand this: An individual, born in Mexico is deemed a tax resident of Mexico, under its internal tax code.^xxv In 2023, such individual moves to the United States under a TN visa^xxvi on March 1, with the intent to work at a US business in which he has been granted some shares. On November 15, due to a family matter, he returns to Mexico on a permanent basis. During such period, the entity in which he was granted shares, elected to be treated as an S corp. What is the result here for the individual and for the S corp? Was the S corp really allowed to have such individual as a shareholder?

First, let us discuss the tax implications for the individual for 2023. Under US law, the individual would be treated as a US tax resident because such person meets the substantial presence test. However, he would also be treated as a tax resident of Mexico.

This would result in such individual being subject to income tax in both Mexico and the United States on his worldwide income. In other words, double taxation results.

To prevent such a result, a first option to prevent double taxation would be for the individual to claim that he had a closer connection with Mexico.^xxvii Under this exception, a resident under the substantial presence test would be treated as a nonresident. If the Mexican individual is treated as a nonresident, he would pay tax in the United States only on the income that is derived from US sources. Unfortunately for our individual, is that one of the requirements of the closer connection exception requires that the individual is present in the United States less than 183 days in the current year.^xxviii This renders the exception unapplicable.

A second option would be to claim the benefits of the tax treaty between Mexico and the United States. Under the tax treaty, the Mexican individual could claim that his tax residence was located in Mexico, and not the United States because his center of vital interest was in Mexico.^xxix

Another trap for the unwary here is that the application of tax treaty benefits is not automatic. The IRC requires that in certain cases, a treaty-based position shall be reported. In this particular case, given that the Mexican individual is determining his tax residency under the treaty, the reporting of such position is mandatory.^xxx To disclose the treaty-based position, the individual would need to file Form 8833, Treaty-Based Return Position Disclosure Under §6114 or 7701(b).^xxxi

A slight (big) problem arises here: If an individual applies the benefits of the treaty, such benefit is limited to establishing the individual’s US income tax liability as a nonresident.^xxxii However, (and this is the most relevant part of this article) the individual is still treated as a US resident for all the other Code purposes.^xxxiii

Some of you may wonder if this is improper, and inconsistent. But the regulations clearly support this reading in an example: If an individual applies treaty benefits and elects to be treated as a nonresident, such person will still be treated as a resident for other purposes of the IRC, and the regulations provide an example for determining who qualifies as a shareholder of a controlled foreign corporation (CFC). In such case, “the individual shall be treated as a United States resident for purposes of determining whether a foreign corporation is a controlled foreign corporation under section 957 or whether a foreign corporation is a foreign personal holding company under section 552.”^xxxiv

In other words, this means that the individual will be treated as a nonresident only for purposes of determining his tax liability in the United States, but he still will be treated as a US resident for any other purpose. In our example, the Mexican individual will be treated as a nonresident only to determine how much tax he owes to the United States from his income obtained in the US. But he will still be considered as a resident for any other purpose of the Code (Attention: For example, if he is a “resident” for purposes of being a shareholder in the S corp he was granted the shares).

This means that in our case, the Mexican individual will be treated as a nonresident for purposes of how much income tax he owes to the United States. But he still will be treated as a resident (under the substantial presence test) for other Code purposes, such as the qualification to be a shareholder in the S corp. Here, he qualifies to be a shareholder of the S corp because during 2023 he met the substantial presence test. As we discussed before, an individual that meets such test can be a shareholder in an S corp. In other words, a nonresident can be the direct shareholder of the S corp.

Such contradiction was already identified by the IRS more than 25 years ago; however, it never acted upon it. Final regulations issued on April 27, 1992, implementing the rule for coordination with tax treaty, as provided under Treas. Reg. §301.7701(b)-7 described above, the IRS noted that “Commenters also question whether an alien individual described in paragraph (a) of §301.7701(b)-7 who claim a treaty benefit may be an S corp shareholder. Proposed regulations published elsewhere in this issue of the Federal Register addresses this issue and new paragraph (a)(4) “Special rules for S corporations” of these regulations has been reserved. See Notice of proposed rulemaking (INTL-121-90) published elsewhere in this issue of the Federal Register.”^xxxv

When reviewing the Notice of proposed rulemaking (INTL-121-90), the IRS clearly states in the preamble that:

“Section 301.7701(b)-7 of the regulations provides, in general, that if a dual resident taxpayer (an alien individual who is a resident of both the United States and a foreign country with which the United States has an income tax convention) claims a treaty benefit as a nonresident alien with respect to an item of income covered by the treaty, the individual will be treated as a nonresident for purposes of computing the individual’s United States income tax liability under the Internal Revenue Code. Congress has made it clear (by the enactment of section 1361(b)(2)(C)) that nonresident aliens may not be shareholders of an S corporation. In order to ensure that at least one level of U.S. tax is paid on an S corporation’s earnings, paragraph (a)(4)(iii) of section 301.7701(b)-7 is proposed to provide that for purposes of determining whether a domestic corporation meets the definition of an S corporation under section 1361(a)(1), a dual resident taxpayer who claims a treaty benefit (as a nonresident of the United States) so as to reduce the individual’s United States income tax liability shall be treated as a nonresident alien of the United States. Accordingly, if the dual resident taxpayer is a shareholder in an S corporation for any portion of a taxable year with respect to which the taxpayer claims a treaty benefit, then the corporation’s election under section 1362(a) shall be terminated pursuant to section 1362(d)(2) effective on the first day of the dual resident’s taxable year with respect to which the dual resident taxpayer claims a treaty benefit. A dual resident who does not claim treaty benefits to reduce U.S. tax will not be subject this rule, and thus, may be or become shareholder in an S corporation.”^xxxvi

This explanation confirms the conclusion that a dual-resident individual (such as in our example) can claim the benefits of the tax treaty to reduce his tax, will still be treated as a resident for purposes of being treated as a shareholder in an S corp. The intent of the proposed rule is
precisely to prevent such results.

However, such regulations never became final. And if one reads the text of the current regulations, there is a provision on Treas. Reg. §301.7701(b)-7(a)(4) which is titled as “Special rules for S corporations. [Reserved].” The rule was never implemented, which means that
the nonresident can still claim those tax treaty benefits and be a shareholder of the S corp.

Conclusion
Although the question as to who could be a shareholder in an S corp seems straightforward, that is not the case anymore. Especially after the TCJA and whenever international tax becomes involved, such plain definitions can become quite tricky. It is always suggested that the tax professional reviews the statute and its regulations to prevent falling prey to fables or myths. In this article we have thrown away old myths about who can be a shareholder of an S corp and have discussed the scenarios in which a nonresident can hold stock indirectly and directly in an S corporation.

DISCLAIMER: The information provided in this article does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available in this article are for general informational purposes only.

The discussion as to whether a nonresident applying tax-treaty benefits being an eligible shareholder of an S corporation may be subject to litigation because there is no specific IRS guidance on this point. Proposed regulations are not binding law. A specific analysis of the proposed regulation must be made to determine whether the taxpayer may rely on those regulations. As always, the review of the law is the best avenue to determine the position taken.