Is An S-Corporation Right for Your Startup?

In my Phoenix emerging business law practice, I’m regularly asked to incorporate a client’s startup company. However, I’m often met with a founder’s blank stare or “Um…” when I ask them if they wish to be considered a C or an S-corporation.

Let me remind the reader that I am not a CPA or tax attorney and that you should always (and I mean always!) discuss your and your co-founders’ specific tax situation and business and capital raise goals with your CPA or tax advisor before making a Subchapter S election for your startup.

Aren’t all corporations just…well, corporations?

Not exactly. When you incorporate your startup company, for Federal taxation purposes anyway your new corporation will be treated by default as what is known as a “C” corporation (based on the subchapter designation of the Internal Revenue Code).

The advantages and disadvantages of being treated as a C-corporation are beyond the scope of this post. Fortunately, there are tons of useful articles you can find online that discuss this issue ad nauseum.

If your company and its immediate financial or capital raise prospects don’t really lend itself to being treated as a C-corporation, fortunately the IRS does provide you with an “out”. You can formally elect to be treated as an “S” corporation instead.

The S-Corporation

Viewed from the 30,000 foot level, an S-corporation election gives startup founders most of the advantages of the basic corporate form with the tax advantages of the partnership (and by extension the ever-popular limited liability company (“LLC”)) form of legal structure.

By selecting S corporation status, the business owner (or owners) are allowed to pass corporate income, losses, deductions, and credits through the business directly to the shareholders, who can then take (i.e., report) that very same income, losses, deductions, etc. on their individual tax returns.

In other words, shareholders of S corporations report the flow-through of income and losses on their personal tax returns and will then be taxed on it at their individual income tax rates.

Thus, the biggest benefit to treatment as an S-corporation is that it allows the company to avoid the “double taxation” of a C-corporation. In other words, the taxation of business income at the corporate level and subsequently later at the shareholder level from dividends and distributions of income from the corporation. After all, who among us wants to be taxed twice?

S-corp shareholders can also deduct 20% of qualified business income from their personal tax returns. Exceptions do apply, of course, so always check with your CPA or tax advisor first if you’re considering S-corp status.

Why doesn’t every startup elect S-corporation status?

So if S-corp status is a nice blend of traditional C-corp and LLC, then why wouldn’t every startup make such an election? Well, the reasons are actually many and significant.

If, as is the case with most startups, your business is in growth stage and you are planning to reinvest most of the company’s profits back into the business anyway, thus foregoing or limiting distributions to shareholders, sticking with the C-corp may work out better.

Moreover, S corporations can be liable for tax on certain built-in gains and passive income at the corporate level. Consult with your CPA or tax advisor for more details on this.

But one of the biggest drawbacks with the S-corporation are the various limitations on who can and cannot be a shareholder of the S-corporation. These shareholder restrictions can pose some serious considerations for new, particularly technology-oriented, startups.

For starters, S-corporation shareholders can be individuals, certain trusts, and estates, which is perfectly fine for most businesses. However, S-corp shareholders cannot be partnerships or corporations.

As many if not most venture capital and institutional investment firms are partnerships or LLCs, this limitation can pose significant challenges in trying to raise capital from these institutional outside investors.

The restriction on ownership of an S-corporation by another corporation might similarly affect the odds of an acquisition or merger of your startup by a corporate acquiror.

Similarly, an S-corporation can have only one class of stock for the company. This restriction on having alternate class of shares with different voting rights or other economic advantages could similarly turn off institutional angel investors and VCs that might otherwise overlook the other issues inherent with S-corporations.

S-corporations are also prohibited from having more than 100 shareholders. This limitation would obviously jeopardize any eventual plan or exit strategy that involves an initial public offering of the company’s stock on the regulated, public markets.

From the standpoint of seeking a co-founder or key talent to join your team with the promise of equity, the S-corporation again comes with certain challenges, since “non-resident alien” shareholders are prohibited.

This can be a serious limitation for young companies having or anticipating having founders or co-founders that are not at least U.S. lawful permanent residents but also for the company’s plans to offer incentives such as option grants to existing or prospective employees who are also not already “Green Card” holders. Needless to say, offering or granting stock options to, say, a holder of a nonimmigrant visa such as an H-1B or L-1 would be off the table lest the corporation wish to jeopardize its S-corp status.

As if all of the above weren’t enough, there are additional restrictions that come with S-corporations, however, the ones discussed are really the biggest drawbacks that we counsel on when it comes to our startup clients in the technology or biotech space.

S-corporations aren’t for every Startup

Which isn’t to say that S-corporations aren’t terrific option for some. For example, you might be starting a new business in which you and your co-founders plan for the business to be:

– at revenue quickly
-a “cash cow” with limited or no re-investment back into the company
-able to bootstrap itself along to growth and eventual “exit”
-limited shareholders and share classes
-foresees no need for outside investment from VC or institutional firms

While the dreaded “double taxation” of C-corporations can be a hefty concern and one not to be taken lightly, the potential drawbacks and disadvantages of choosing the S-corporation form as a startup, particularly as a technology or biotech company, should not be ignored.

Founders who are considering incorporating (or who have recently incorporated) their startup should consider retain legal counsel as soon as possible to discuss this all too often misunderstood and ignored aspect of the startup formation process. In many instances, the advice of an experienced attorney can help avoid significant or costly delays related to corporate governance, hiring of key employees, and even availability of outside investor funding. To schedule a consultation with our Phoenix startup law firm, call our office today at (602) 222-5542 or send us an e-mail through the online contact form to the right.

Ben Bhandhusavee is the Managing Attorney for BHANDLAW, PLLC, a startup, technology, and e-commerce law practice advising founders and management teams on company startup, corporate and technology transactions, e-commerce, as well as Internet privacy concerns. The firm serves corporate and individual clients throughout Arizona, the United States, and internationally. Our offices are conveniently located along the Camelback corridor in Phoenix’s financial district. For more information about our Company Startup practice, feel free to reach out using the contact form on the right or call us at (602) 222-5542 to schedule a meeting. Connect with Ben on LinkedIn or Avvo.