In our post about choosing the best form of entity for your company, we noted that both corporations and limited liability companies offer owners the option of choosing whether the income of the business will be attributed directly to the owners, and therefore taxed at each owner’s applicable individual tax rate, or taxable to the company. In this entry we discuss why a corporation might choose to have business income attributed directly to its owners and certain restrictions applicable to corporations that do so.
Absent an election to the contrary, a corporation pays tax based on its income at the applicable corporate tax rate (such corporations are known as “C Corporations”). This creates double-taxation – income of the business is taxed first at the corporate level and then again at the stockholder level when dividends and other distributions are made. This differs from the income tax treatment of a partnership, where income, deductions and credits flow to the individual partners and no tax is collected at the partnership level. To level the playing field between corporations and partnerships, Subchapter S of Chapter 1 of the Internal Revenue Code provides that a corporation electing to be governed by Subchapter S (such a corporation is known, not surprisingly, as an “S Corporation”) will be taxed as a partnership, thereby eliminating income tax at the corporate level. Stockholders of S Corporations include their portion of the corporation’s income, deductions and credits on their personal income tax return, while still benefiting from, among other things, the limitations on personal liability enjoyed by stockholders of a C Corporation. S Corporation status may be elected by filling a completed IRS Form 2553 with the Internal Revenue Service and once made the election stays in effect until terminated by the company or revoked by the IRS. Elections made after the 15th day of the third month after your corporation’s fiscal year end will be effective for the following fiscal year, though late elections are permitted under certain circumstances.
While electing S Corporation status may result in a lower effective rate of tax on income of the business, there are certain restrictions imposed on S Corporations that may prove challenging for emerging companies, including:
1. S Corporations may only issue one class of stock. This restriction is most relevant when seeking venture capital financing because venture capitalists prefer to make their investments in exchange for preferred stock, a separate class of stock carrying rights that are different from, and in many cases superior to, those carried by a corporation’s common stock.
2. S Corporations must have 100 or fewer stockholders. Emerging companies often use equity incentives, such as stock options, as a form of compensation. A limit on the number of stockholders may prove difficult to accommodate as a company grows.
3. Stockholders of S Corporations must be U.S. citizens or residents, and may only be physical persons (or certain specific types of tax-exempt entities). This precludes investment by venture capital funds, which are not physical persons and do not qualify under the exceptions, as well as investment by foreign nationals or businesses.
4. Profits and losses must be allocated in accordance with stock ownership when realized. This means that all amounts made or lost must be attributed to the S Corporation’s stockholders when made or lost – and are immediately taxable – even when the earnings are retained by the business and not paid out. This issue can be mitigated with a stockholders’ agreement providing for a mandatory payout of an amount at least equal to the stockholders’ individual income tax liability relating to the business.
The import of these restrictions is lessened somewhat because corporations that have elected S Corporation status may subsequently choose to be treated as C Corporations (and vice-versa), but other considerations (such as the applicable tax rates of the corporation and the stockholders) may also impact the benefit of making an S Corporation election. It is, therefore, very important that you consult with your legal and tax advisors before making an S Corporation election.
Tags: C Corp, Charter, S Corp, S Corporation, S election
Tags: C Corp, Charter, S Corp, S Corporation, S election