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Business Entity Formation 101: S-Corps

Brian Hall - March 18, 2020 - Business Law, Entity Formation

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S-Corps are an attractive middle ground between the C-Corp and other entity types. S-Corps are subject to many of the same legally mandated formalities as C-Corps, but are taxed on a pass-through basis like non-corporation entities such as Partnerships and LLCs. An especially convenient advantage to the startup is that S-Corps can convert to C-Corps with no hassle.

Like most other business entities, S-Corps limit the personal liability of its owners. This means that your personal assets—your home, automobile, savings, and so on—are not vulnerable if the company takes a downturn.

The most important characteristics of the S-Corp include:

The most important characteristics of the S-Corp include:

  • Limiting the financial liability of its owners;
  • Being subject to several formal requirements;
  • Passing income and losses directly to its owners;
  • Having its profits taxed only once; and
  • Being easily able to convert to a C-Corp.

Passing Through

Like LLCs, Partnerships, and other entities, S-Corps pass their profits and losses through to the owners. This sounds riskier but has an important upside: no double taxation. In a C-Corp, the corporation is taxed on its income and, if the C-Corp elects to pay its shareholders dividends, the shareholders are taxed on that income. So, the funds that pay the dividend are diminished through taxation and then the dividend itself is taxed.

However, in an S-Corp, the income passes directly to the owners. Therefore, it is not taxed at the Corporate level. The owners must receive income if the company turns a profit, and it is only taxed once!

Formalities Required

Whether C-Corp or S-Corp, corporations are subject to a variety of legal formalities. These include basic organizational requirements, the keeping of records, and various reporting requirements. For example, every corporation must have a Board of Directors (or its equivalent) with a minimum number of Directors. Every corporation must have certain officers, like a CEO, President, and Secretary. And every corporation must keep a record of the meetings of its Board.

Equity for Employees and Investors

One of the most well-known features of the Corporation is stock, portions of which are represented by shares. Stock is ownership, or equity, in the company. For many small companies, equity is provided to employees as part of their compensation. Equity is also provided to investors in exchange for their investment of funds and other resources.

Small businesses must usually be especially efficient in how they spend money. In order to attract the best talent available, many offer shares of the company as part of their compensation package. The company provides value to the employee without dipping more deeply into its lean financial accounts. It also encourages employees to put in their best work: as the company does better, their shares become more valuable!

Investors, and especially sophisticated investors like venture capitalists, angels, and larger companies, very often seek equity in the company in exchange for their investment.

The S-Corp is at a disadvantage here, compared to the C-Corp. S-Corps are subject to various restrictions with respect to its shares, including a limitation to a single class. So, much like the LLC, all S-Corp ownership is created equal. This doesn’t please investors, because they usually require privileged stock in exchange for their investment. After all, they’re providing a lot of money and will want to be able to ensure their investment’s health. This is part of why most professional and sophisticated investors restrict their investing activities to C-Corps.

But the S-Corp has an easy way to meet this challenge . . .

Simple Conversion

S-Corps are readily convertible to C-Corps. In fact, at bottom, an S-Corp is a C-Corp! It is subject to the same legal requirements. Its founding documents are the same. The S-Corp simply must satisfy certain qualifications and make certain elections with the IRS. Once it needs to convert, it notifies the IRS. Suddenly, C-Corp!

If your company plans to seek capital investment (looking at you, startups), an S-Corp provides a great way to keep things simple, enjoy preferable tax treatment, set up the company fundamentals once and for all, and convert to a C-Corp when the time is right.

All That Said . . .

As in any business decision, context is key. The attractiveness of the S-Corp will depend on your circumstances. Are you the sole owner, or one of several? Do you desire capital investments in exchange for equity? What are the implications of the pass-through structure as compared to the C-Corp structure? What state will your company be organized in?

If you’re unsure, don’t be! Traverse Legal has extensive experience advising clients on the entity that’s right for their goals. Our expert attorneys can advise you on the legal and business considerations that matter both at the outset of your new business journey and those down the road. We can help set out the complete context so you can make the best decision for your business, with certainty.

This blog post contributed, in part, by Traverse Legal Virtual Law Clerk Eric O’Neill.

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