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Why (not) form an S corporation?

Some companies are formed as S corporations to avoid “double taxation”: The corporation does not pay federal income tax. Instead, income flows through to the shareholders, who pay income taxes (as in a partnership).

This potential tax benefit is available, however, only if stringent requirements are met. Most notably:

  • There must not be more than 100 shareholders.
  • Permissible shareholders are limited to individuals (other than non-resident aliens), estates, tax-exempt organizations, and certain qualified trusts.
  • Only one class of stock is permitted.

Failure to meet a requirement, even if inadvertent, results in loss of S corporation status.

Entrepreneurs should think carefully about whether S corporation status is appropriate for the long term. Here’s why.

A client company was started almost a decade ago. All this time, the founders have retained S corporation status because it has been beneficial to them.

However, during the past year, revenue and the number of employees have grown dramatically. The founders would like to reward employees with shares of stock, but the S corporation limitation of a single class of shares makes the desired equity compensation plan impossible.

As a result, we are forming a new limited liability company (largely owned by the S corporation) that will offer flexibility in awarding equity to employees while retaining the existing S corporation’s benefits for the founders. This sophisticated structure will give the company what it needs, but planning and implementing it requires substantial time, energy and money. I have to wonder whether a different decision would have been made up-front if this outcome had been foreseen.

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This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.

  1. 5/22/2010 | 10:13 pm Permalink

    Is it feasible to setup a S-Corp, but easily convert to a General Corp at a future date? And when you lose your S-Corp status, doesn’t it inadvertently become a General Corp which can issue multiple classes of shares, albeit forcing taxation to be treated differently?

    “I have to wonder whether a different decision would have been made up-front if this outcome had been foreseen.” — in retrospect what would have been your recommendation that would have helped them avoid the double taxation but appropriately setup for future growth / changes?

    Thanks in advance for the insight!

  2. 5/23/2010 | 8:35 am Permalink

    @Amar
    Yes, the conversion from S to C corporation is easy – indeed, it is automatic if you do anything that is not permitted by an S corporation, such as authorizing a second class of shares.

    In the case of my client, while I am not sure whether anyone at the time of founding could have foreseen the state of affairs a decade later, the obvious alternative in hindsight is to have started as an LLC in the first place: The founders would have had pass-through tax treatment, and the LLC’s operating agreement could have been amended to add the employees’ equity interests with far less complexity than now is required.

  3. 5/23/2010 | 9:43 am Permalink

    Thanks Dana. That makes sense… and I’m assuming if they had started as a CA (or Delaware) LLC, but required VC funding of any sort along the way, there would be a way to migrate to a CA (or Delaware) C-Corp?

    Also, was wondering if you could cover some perspectives on “closed” corporations, how they differ from C-Corps, S-Corps and LLCs, and what factors/situations make it attractive.

    Your blog is a fantastic source of information, thank you!

  4. 5/23/2010 | 1:05 pm Permalink

    @amar
    Thanks for the kind words.

    Yes, it is straightforward to convert from an LLC to a corporation – you need to realize, however, that there could be a tax hit at that time, depending on the LLC’s specific tax situation.

    Although CA law allows for “statutory close corporations”, they are rarely used, and I have never formed one. The reason: The benefit – dispensing with corporate formalities, accomplished by tweaking the articles of incorporation and entering into a shareholder agreement – can be accomplished more easily and more flexibly by forming an LLC.

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