What about the S corporation?
An S corpora4on provides the organiza4onal structure of a corpora4on and pass-through taxa4on similar to that of a partnership (with several notable differences). The difficulty for many startups in choosing S corpora4on en4ty status is that the business ac4vity must meet numerous requirements in order to qualify for the elec4on. Recall, there can be no more than 100 investors, each must be an individual, an American ci4zen (or resident alien), and there can only be one class of equity ownership. All of these factors are of primary concern to growth- based startups.
• Note: Remember that the startup venture is growth-based. It depends upon outside capital from investors to achieve its growth targets. Many outside investors, such as venture capital firms, are businesses. An S corp does not allow these business en44es to own an equity interest in the business. Further, outside investors generally purchase a preferred class of business ownership. The S corp does not allow for the designa4on of a preferred or special class of ownership. Each of these issues is discussed below.
What tax benefits exist for the S corpora.on?
The primary benefit of an S corpora4on is pass-through taxa4on. That is, the business en4ty does not pay taxes; rather, the income or losses of the business ac4vity pass through the
business en4ty and are reported on the income tax returns of the individual owners. In this regard, the S corpora4on enjoys the structural characteris4cs of a C corpora4on with a tax structure very similar to that of partnership and LLCs. Other beneficial income tax characteris4cs of the S corpora4on are as follows:
- Passive Income – Owners of an S corpora4on treat business profits as passive income. Owners working in the S corpora4on must receive a salary for services rendered to the business. This salary is subject to payroll taxes for the employer and employee. Passive income for shareholders who are not “material par4cipants” in the organiza4on is subject to ordinary income tax rates, but is not subject to payroll taxes by the business or the employee.
- Basis Adjustments – Like a partnership-taxed en4ty, the S corpora4on shareholder’s basis is adjusted up or down by earnings and distribu4ons of the business. The individual shareholder pays income taxes on her share of the S corpora4on profit. If the S corpora4on retains (does not distribute) any profits, the shareholders’ basis in the business increase by this amount.
What tax detriments exist for the S corpora.on?
The primary tax detriment of the S corpora4on is the counter to the advantages of the S corpora4on tax structure. That is, losses that pass through the S corpora4on to shareholders who do not “materially par4cipate” in S corpora4on ac4vi4es are passive losses. Passive losses can only be used to offset passive income. Another common tax detriment is the inability to make special alloca4ons in the S corpora4on. That is, shareholders receive a percentage of business profits and losses based upon their respec4ve ownership interests in the en4ty. In contrast, partnership-taxed en44es are able to make special alloca4ons to shareholders and C corpora4ons are able to issue preferred stock that may alter the distribu4on of business profits or losses.
How does the S corpora.on compare to the LLC as a startup entity?
The 100 investor limita4on is not a primary area of concern between an LLC and S corpora4on, as most startups do not achieve this mark before going through extensive equity offerings. Both en44es provide similar flow-through structures for taxa4on. If the startup requires adherence to the corporate en4ty structure (shareholders, directors, and officers) then the S corpora4on avoids the burdens of establishing these roles through contractual arrangement.
The first major drawback of the S corpora4on is the limita4on to one class of equity security. The S corpora4on, unlike the LLC, does not allow for profit-only interest stakes in the venture. This type of interest may be considered a security and disqualify the en4ty from S corpora4on status.
• Example: Alfred is an angel investor. He iden4fies Morgan’s startup as a promising venture. Morgan is currently organized as an S corpora4on. Alfred is not interested in common stock in the S corpora4on. He wants to make certain that when the business is sold in the future that he will receive a return on his investment before Morgan or anyone else receives any of the proceeds. As such, he asks that Morgan convert the en4ty into a C corpora4on. She can then authorize a second class of preferred stock that has a liquida4on preference. When Alfred invests in the business, he will receive preferred stock in exchange for his invested capital.
• Note: Recall, preferred shares allow a special alloca4on of interest (dividend, liquida4on preference, decision rights, etc.) that are not available to the common stock holder. S corpora4ons and LLCs cannot issue preferred stock, but the LLC can issue alterna4ve interests that are not available to the S corpora4on. The profit-only interest is a common LLC right given to outside investors who seek special rights.
A second drawback is that the S corpora4on does not allow for special alloca4ons of profits and losses. Each shareholder must share in the income in direct propor4on to their ownership interest.
- Example: Bob, Kate, and Julie form an S corpora4on for their business and each hold the same number of shares in the business. Bob works in the business part-4me, Kate works full 4me and Julie is just a silent investor. Bob and Kate will receive a salary for their work in the business. Aaer that, all profits of the corpora4on are distributed equally to the owners. All three shareholders realize that the business is successful based largely on the efforts of Bob. They determine that Bob should receive more of the business profits that Kate and Julie. They are disappointed to learn that they cannot make a special alloca4on of profits to Bob that is different from his ownership percentage. If they were an LLC, then they could make this special alloca4on. They decide to pay Bob an addi4onal bonus as part of his salary rather than an addi4onal alloca4on of business profits.
- Note: Most startup investors do not wish to receive a distribu4on from the business ac4vity. The money is beFer reinvested to grow the business. These businesses will, however, seek to use an alloca4on of losses to offset other income. The ability to specifically allocate income or loss could be an important draw to an outside investor.A third important dis4nc4on between the LLC and S corpora4on is how business profits are taxed to the owners. In an LLC the members pay ordinary income taxes (possibly including self- employment taxes) on their distribu4ons received from LLC profits. This result is largely the same whether the LLC is member-managed or manager-managed. In an S corpora4on, employee-shareholders receive a salary for their services to the business. They also receive a distribu4on of business profits based upon their percentage of ownership. These employees pay ordinary income and self-employment taxes on their salary. They also pay ordinary income taxes on their distribu4ve share of profits. While employee shareholders pay self-employment taxes on their salaries, S corpora4ons shareholders who are passive investors do not pay self- employment taxes on their distribu4ve share.
• Example: In the above example, Bob receives both salary and a distribu4on of profits from the S corpora4on. His salary will be subject to payroll taxes. He will pay a por4on of those taxes and the business will pay the other por4on. His share of S corpora4on profits, however, is treated as passive income. He will be subject to income tax on his share of income but will not have to pay self-employment taxes on that amount.
• Note: The fact that passive investors in the S corpora4on (or any corpora4on for that maFer) do not pay self-employment taxes on their share of income is a huge advantage to those investors (such as angel investors and venture capitalists). This fact alone leads many investors to prefer the S corpora4on status over the LLC. The IRS has considered aligning the taxa4on of distribu4ons to members of a member-managed LLC with those of passive investors in an S corpora4on. The recommenda4ons were made more than a decade ago, but Congress has not yet acted on the recommenda4ons.
Another disadvantage is that funds guaranteed on behalf of the S corp are not part of the basis or at-risk amount of shareholders. This means that personally guaranteeing a business loan does not provide the tax advantages available to the partnership or LLC. If a business expects to incur extensive losses in a given year, then investors may seek to use these losses to offset their other income. Rather than invest all of the money employed by the business, many investors/ owners will personally guarantee third-party loans to the business. In a partnership (and LLC) these loans raise the investor’s basis in the business, so that sustained losses can be used in excess of the actual capital invested. An S corp does not allow an increase in basis for personally guaranteed loans. As such, some of the losses incurred in the business may not be useable by the investors due to basis limita4ons. Lending money directly to the corpora4on, however, will help the shareholder in using the losses by increasing her “debt basis”.
• Note: The inability to increase one’s basis by personally guaranteeing loans is not a large concern for outside investors. Angel and ins4tu4onal investors do not frequently guarantee loans; rather, they infuse cash whenever needed.
Lastly, and perhaps the most important limita4on for startups in choosing an S corpora4on en4ty status, is the requirement that all members be individuals (not businesses). Venture capital firms are organized as LPs, with an LLC or corpora4on serving as general partner in the rela4onship. The LP will invest funds by purchasing equity in the business en4ty. This arrangement effec4vely prohibits venture capital investment in businesses organized as S corpora4ons.
• Note: This may not be an issue for early stage startups who seek angel investment. Angel investors are high-net-worth individuals who invest (much in the same way as venture capital firms) in startup ventures. These individuals may be willing to invest in S corpora4ons, and they do not run afoul of the individual investor requirement.