Why Are Non Resident Aliens Not Allowed to Be Stockholders in an S Corporation?
In order for a corporation to qualify for special tax treatment under Subchapter S of the Internal Revenue Code (IRC), it must comply with certain restrictions on the ownership, type and transferability of its stock. When the S corporation election is made, the shareholders attest, under penalties of perjury, that the corporation's ownership and structure comply with IRC regulations. (Reference 5)
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Definition
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A nonresident alien is a citizen of some other country and is in the United States only on a temporary basis. The nonresident does not pay taxes to the U.S. government in the same way that a citizen or a resident alien does. A nonresident alien only has to pay taxes on income generated in the United States and not on worldwide income, unlike citizens and resident aliens.
Purpose
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The purpose of an S corporation is to enable small corporations to avoid the encumbrances of a regular corporation when the small corporation has no intention of going public or offering ownership in exchange for capital to the public at-large. It enables the small corporation to retain the benefits of the corporate structure while allowing it to be taxed like a partnership.
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Requirements
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The IRC prohibits nonresidents from being shareholders of an S corporation. Shareholders are restricted to individuals who are citizens of the United States or resident aliens. This restriction is explicitly stated in the IRC at section 1361(c). The form that must be filed to elect S corporation status (Form 2553) requires the signatures and Social Security numbers of all shareholders as proof of the shareholders' eligibility.
Rationale
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The reason a nonresident alien cannot be a shareholder of an S corporation has to do with the special tax status that the election provides to the shareholders. Profits and losses from an S corporation pass through to a shareholder's personal income tax return in proportion to his ownership interest and are taxed at the individual tax rate. A nonresident alien does not pay taxes to the United States; he pays taxes to his own country. Alternatively, if he does pay some tax in the United States on income generated there, it is not on the same gross income as a citizen, since a citizen has to pay taxes on worldwide income and a nonresident does not. The bottom line is that it is more likely that the Internal Revenue Service will lose the ability to properly tax the corporate income attributable to a nonresident, since it doesn't have the same checks and balances in place for the alien as it does for a citizen with a Social Security number. As a result, the nonresident alien is excluded as an eligible S corporation shareholder.
Warning
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Make sure that shares of an S corporation are never transferred to an ineligible shareholder, such as a nonresident, or that a shareholder does not later become ineligible, even after the filing of the election form. Having an ineligible shareholder will retroactively cancel the corporation's tax election, as indicated in the instructions to the tax return that an S Corporation files (Form 1120S). It is relatively easy for the IRS to keep track of this sort of thing when taxes are filed at the end of the year.
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