Every business owner has to choose the type of entity they will establish through which to conduct their business. This choice can have important implications on how the business is taxed, how it will be permitted to raise capital, and how easy it will be to sell the business when the business owner decides to exit. Clearly, this is an important decision. This post is the first in a series on choice of entity.
S corporation characteristics
S corporations are regular business corporations that elect to be taxed as small business corporations. They are formed by filing articles of incorporation with the secretary of state and are subject to the state’s corporations law. Among other things, the entity’s articles of incorporation provide for the number and par value of authorized stock (for a discussion on what this means, see my post Stock Basics) and the number of directors who will sit on the board. The corporation’s governance will be controlled by its bylaws, policy decisions will be made by its board of directors, and day-to-day operations will be carried out by its officers. In short, they are just like regular business corporations in every way, except for how they are taxed.
S corporation taxation
S corporations are what are commonly known as pass-through entities. That is, the corporations’ shareholders are directly taxed on the corporations’ income and expenses. This saves a significant amount of income tax as compared to regular corporations, which are known as C corporations. C corporations are taxed on their operations, and then the same income is taxed again when the profits are distributed to the shareholders. This double tax can be quite expensive. S corporations solve the double-tax problem by by-passing corporate-level tax.
Another tax issue has to do with payroll taxes. As we’ll discuss in future installments of this series, there are other entity types that provide for pass-through taxation, such as sole proprietorships and partnerships. But their profits are also subject to self-employment tax.
Self-employment taxes are imposed on the owners of businesses in lieu of payroll taxes. If you are a w-2 employee, you pay 7.65% of your wages for payroll taxes (6.2% for Social Security and 1.45% for Medicare), and your employer also pays that amount for a total of 15.3%. The IRS captures these taxes from self-employed individuals and certain business owners by imposing a 15.3% self-employment tax. The Social Security portion of self-employment taxes is imposed on the first $127,200 of income, and the Medicare portion is imposed on all income (these are 2017, but the amount is indexed to inflation). Thus, these business owners will pay 15.3% of the first $127,200 of income. For a good explanation, see How Self-Employment Taxes Work.
S corporation shareholders are not subject to self-employment taxes. S corporation shareholders who work in the business are employees of the company and are subject to payroll taxes instead. Thus, if an S corporation shareholder’s salary is less than $127,200, then their payroll tax obligations will be less than if the shareholder were subject to self-employment taxes. This is a possible tax savings for S corporation shareholders over owners of other pass-through entities.
Of course, the IRS in on the lookout for people who abuse this situation by paying themselves an unreasonably low salary. So S corporation shareholder-employees need to pay themselves reasonable salaries to avoid running afoul of the IRS.
These tax benefits of S corporations are great, but there are some trade-offs, because S corporations are subject to some key restrictions.
S corporation restrictions
The most significant restrictions are the single class of stock rule and the rules on who can own S corporation stock.
Single class of stock
S corporations can only issue a single class of stock, so they can have only common stock. At its most basic, this rule means that every share of stock has the same right to distributions of the company’s profits and assets as every other share. This can take away a lot of flexibility that business owners desire.
For example, two people are setting up a new business and want to be 50-50 owners. But if they each own 50% of the stock, then neither will have a majority vote, so they run the risk of becoming hopelessly deadlocked over important issues. Some people solve this problem by giving one of the shareholders a slight majority of the stock, say 51%. But they want to share the profits on a 50-50 basis. They can’t do this with S corporations, because every share of S corporation stock is required to have the same rights to the corporation’s distributions and assets as every other share. (Actually, this result could be achieved by issuing the same number of shares of stock to both owners, but making a small portion of the stock issued to one of the shareholders non-voting stock, so there is a relatively simple workaround.)
A more significant example that doesn’t have a workaround involves preferred stock. Often, people who provide capital to a company want to have their capital returned to them before profits are distributed to the shareholders. For example, if a baker wants to set up his own business but doesn’t have enough funds, he might find an investor to put up the money. Let’s say both the baker and the investor are issued 50% of the company’s stock, so they are 50-50 owners. Under this situation, profits would generally be distributed equally to the two owners. But the investor wants to get her money back before profits are distributed. This is usually accomplished by issuing the investor preferred stock that gives the investor preference on distributions until her capital is returned. However, S corporations aren’t permitted to do this because of the single class of stock rule. (For more information about preferred stock and how it works, see my post Angel Investing Basics.)
There really isn’t an easy workaround for this. So if business owners want to have preferred distributions, S corporations might not be the best choice of entity for them.
Restrictions on S corporation shareholders
Another key restriction is that only certain people can own S corporation stock. Generally speaking, only individuals who are U.S. residents or citizens can own stock in an S corporation. This means that S corporations usually cannot be subsidiaries of other corporations, limited liability companies, or other entities. It also means that such entities can’t invest in S corporations.
This is most significant in the context of raising capital. If a business owner intends to raise money from venture capital or similar investors, the investors will almost always insist on investing through an entity that has been set up to hold investments. Since entities generally can’t own S corporation stock, S corporations aren’t well-suited for raising money from such investors. Thus, if a business owner needs flexibility on how it raises capital, they probably shouldn’t form an S corporation.
Another restriction is that S corporations can have no more than 100 shareholders. This isn’t an issue for most small businesses, but for startups that intend to go public at some point, the limit on the number of shareholders could be problematic.
Putting it together
S corporations can be a good choice if a business wants pass-through taxation but also wants to be a corporation. For example, some professions are restricted in some states to operating through corporations instead of limited liability companies. S corporations are also a good choice if it is appropriate for the shareholders to pay themselves a salary of less than $127,200.
S corporations aren’t a good choice if the shareholders want flexibility on making preferred distributions, or if they intend to raise capital from venture capital or similar investors. S corporations also can’t be publicly held, so if a business owner intends to take their company public, they won’t be able to do so as an S corporation.