Five Restrictions Founders Should Understand First
For unseasoned founders, making an S corporation election for their new company can sound almost too good to pass up. The business generally avoids entity-level federal income tax, and distributions to a shareholder-employee may avoid burdensome employment taxes that apply to wages. So why are so many venture-backed startups organized as C corporations? The answer is that the same S corporation rules that can produce tax savings for a closely held business can become significant constraints once a company begins raising capital, issuing equity to employees, or planning for an exit.
1. Company Ownership Restrictions
S corporations face strict shareholder eligibility rules. They generally may not have partnerships, corporations, or nonresident aliens as shareholders, although certain trusts, estates, and tax-exempt organizations can qualify. They are also generally limited to 100 shareholders. These restrictions may not matter when a company is owned by two founders, but they can become a major obstacle when institutional investors arrive. Venture capital and private equity funds are frequently organized as partnerships, making them ineligible to hold S corporation stock directly.
2. Single-Class-of-Stock Rule
An S corporation can have only one class of stock for federal income tax purposes. Differences in voting rights are permitted, but outstanding shares generally must provide identical rights to distributions and liquidation proceeds. That restriction is difficult to reconcile with a typical venture or private equity financing, where investors often expect preferred stock with liquidation preferences and other economic rights that differ from common stock. A financing that introduces a prohibited second class of stock will terminate the company’s S election.
3. The Limits of Payroll Tax Savings
One frequently cited advantage of an S corporation is the ability of shareholder-employees to receive both salary and distributions, with distributions generally not subject to self-employment taxes that would otherwise apply in an LLC/partnership. But a working founder cannot simply minimize salary and take the rest as distributions. The IRS requires an S corporation to pay “reasonable compensation” to a shareholder-employee for services performed before making non-wage distributions attributable to those services. If compensation is unreasonably low, the IRS can recharacterize distributions as wages and assess additional employment taxes, interest, and potentially penalties.
4. Potential Restraint on Future Growth
Early-stage companies often evolve quickly from simple founder ownership to option plans, advisor equity, employee incentives, and multiple rounds of outside investment. An S corporation can issue options, but its shareholder eligibility and one-class-of-stock requirements remain in the background as those arrangements become more sophisticated. An option exercise by an ineligible shareholder, for example, can blow up an S election. Founders should therefore consider not just the equity structure they need today, but the one they are likely to need several years from now.
5. How an S Corporation Election Affects QSBS
For many founders, the most important consideration may be qualified small business stock under Section 1202. QSBS must be stock of a C corporation, and the corporation generally must remain a C corporation during substantially all of the shareholder’s holding period. Section 1202 can provide a substantial exclusion of gain when the stock is eventually sold– up to $15 million per shareholder if all conditions are satisfied. However, stock issued by an S corporation can never be QSBS stock, even if the company later changes over to a C corporation. So an S corporation election can mean giving up a potentially significant tax benefit at exit that may ultimately be worth far more than the annual tax savings that made S corporation status attractive in the first place.
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An S corporation can be an excellent structure for the right closely held business, generally one with a limited number of owners, no expectation of raising institutional equity capital, and relatively simple ownership and economic arrangements. Service businesses such as consulting firms and contractors, as well as many local retail businesses, can fit that profile well. But founders building a company that expects to raise institutional capital, issue meaningful equity compensation, or pursue a significant exit should look beyond the immediate tax savings. The question is not simply whether an S corporation can reduce taxes today. It is whether the restrictions that come with the election are compatible with the company you are trying to build.
