Can a Subchapter S Corporation Issue Stock Options?

A Subchapter S corporation can issue stock options to executives and employees just as a traditional corporation can. However, because of government restrictions on "S corp" stock ownership, companies must pay close attention to who receives the options. Carelessness in granting options can be a costly mistake -- one that the company will have to live with for years to come.

Basics

What makes an S corporation different from a traditional corporation -- often referred to as a "C corporation" -- is that the S corp doesn't pay corporate income taxes on its profits. Instead, those profits pass directly to the S corp's stockholders, who pay personal income taxes on them. The federal government created the S corp as a way for small-business owners to enjoy the legal protections of a corporation without the extra burden of corporate income tax. To prevent large corporations from declaring themselves S corps, federal law sets tight rules on S corp stock ownership. Those rules effectively limit how widely a company can distribute stock options.

Restrictions

When a company grants stock options, it's giving the recipient the right to purchase a certain number of shares of the company at a set price. However, to qualify as an S corp, a company cannot have more than 100 total shareholders. In the case of a start-up with just two or three owners, this might not create a problem, as the company can grant options to dozens of employees and still remain under the 100-shareholder limit. But a company that already has 100 shareholders is handcuffed. It can't grant options to anyone who doesn't already own stock, or else it will lose S corp status. Also, by law, non-resident aliens cannot own S corp shares. If a company has a non-citizen on the payroll who doesn't have official resident status -- even if that person is living and working in the U.S. legally -- that person can't exercise options.

Consequences

If an S corp allows too many people to receive and exercise stock options, or it lets a non-resident alien buy shares, or a resident alien who already owns shares loses his resident status, the company's S corp status goes away, and it becomes a C corporation. Under federal law, this shift in status happens immediately when the company no longer meets the definition of an S corp. Reverting to C corp status means it has to start paying corporate income taxes. Further, a company that loses S corp status can't regain it for five years.

Considerations

Under the law defining S corporations, members of a family qualify as a single shareholder. This applies to married couples and to any group of people related by a "common ancestor." In the case of a family-owned company with many family members owning shares, this may create room for more people to receive options.

References

• Habif, Arogeti & Wynne, LLP; Why Does Every Employee Want Stock Options; Mitchell Kopelman, CPA; October 2007
• U.S. Code via Cornell University Legal Information Institute: S Corporation Defined
• U.S. Code via Cornell University Legal Information Institute: S Corporation Election, Revocation and Termination