In Part One and Part Two of the Entity Selection Series, we discussed the benefits of a Limited Liability Company and a C-Corporation for organizing a venture business. In this edition, we will discuss the benefits (and challenges) of an S-Corporation (a “Subchapter S” corporation under the federal tax law, as distinguished from a C-Corporation). The information here gives a broad overview to help illustrate the differences between an S-Corporation, a C-Corporation and an LLC. When selecting an operating entity, an entrepreneur should be mindful of the following legal benefits and notable operating complexities of an S-Corporation:
Formality & Management Structure
The formality and management structures of an S-Corporation are the same as the formality and management structures of a C-Corporation as described in Part Two of the Entity Selection Series. The company is formed as a normal corporation under state law. After the corporation is formed, all the stockholders must sign and file Form 2553 with the Internal Revenue Service (“IRS”) within seventy five (75) days of the formation date to elect S-Corporation treatment for tax purposes. Some states have an analog to S-Corporation status for state tax purposes as well. Furthermore, an S-Corporation must abide by certain restrictions. One of the notable ownership restrictions is the type of businesses that are ineligible to elect S-Corporation status, such as banks and certain insurance companies.
An S-Corporation’s capital structure may only have one (1) economic class of stock, but variations in voting rights are permitted. Generally, all outstanding shares of the S-Corporation’s stock must confer identical rights to distribution and liquidation proceeds.
Moreover, an S-Corporation has restrictions with regards to the amount and type of shareholders it may have involved. An S-Corporation may only have a total of one hundred (100) shareholders. For purposes of an S-Corporation, a shareholder cannot be a nonresident alien and must be a natural person. An S-Corporation may not have other corporations, partnerships, or LLCs as shareholders. That said, certain trusts, estates, and tax-exempt organizations may be permitted to be shareholders.
An S-Corporation will provide directors and shareholders the same corporate liability protections as that of a C-Corporation as described in Part Two of the Entity Selection Series. Generally, the personal assets of a shareholder will not be subject to any legal claim or judgment simply for being a shareholder. However, some exceptions will apply to personal liability for certain actions taken by directors and/or shareholders.
An S-Corporation is (very broadly speaking and with some unique differences such as built-in gain) generally taxed like a partnership. Under the partnership taxation scheme, taxes are not levied on the entity at the federal level and profits flow through to the shareholders to the extent the company generates significant operating income. Partnership tax treatment is the primary reason why S-Corporations are elected as an operating entity along with certain tax benefits that are only beneficial to S-Corporations. S-Corporations are also required to adopt a tax year that is in accordance with IRS regulations. However, in the event that any IRS restrictions set forth for S-Corporations are violated, the company will be treated as a C-Corporation for taxation purposes.
Capital Raising Considerations and S-Corporations
Because of the prohibition on having entities as shareholders, the S-Corporation is incompatible with any investor who wants to or has to invest through an entity (which is essentially any professional investor or fund). Similarly, the fact that an S-Corporation isn’t able to offer any kind of liquidation preference is a severe limiting factor for any investor looking for a preferred return. While terminating the S-Corporation election can be done, there can be significant tax consequences that must be planned against.
For these reasons, an S-Corporation works best in very small co-founder situations, or in circumstances where the company is likely to be funded only by individual investors (or bank debt) who are willing to sit in the same relative position as the founders. If the company is likely to need significant equity capital, an S-Corporation election probably does not make sense.