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.
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.