Many business owners ponder what type of business entity best fits their needs. Some advisors, such as attorneys, like limited liability companies (“LLC”) for start-up businesses. For other start-ups, an LLC is not the best entity, particularly when the business has investors. The pull between the owners and investors is two-fold: investors want to profit from the business, while the owners want profit with reduced taxation.
Enter the S-Corporation. At a very basic level, the S-Corporation combines some elements of a C-Corporation with some elements of a partnership. A main drawback to a C-Corporation is double taxation: C-Corporations have taxation at both the corporate level and at the shareholder level. An S-Corporation eliminates this double taxation by taxing only at the shareholder level: “Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.” Thus, S-Corporations are called “pass-through entities” since profits pass through the corporation directly to the shareholders, where taxation occurs only once, just as it would in a partnership.
There is a tradeoff: the government granted S-Corporations single taxation status, but placed limitations on S-Corporations such as the number of investors and classes of stock.
Shareholders and Stock
S-Corporations cannot have more than 100 shareholders. Each shareholder must be an individual (with some exceptions for an estate and certain trusts and organizations). Each shareholder cannot be a nonresident alien. Finally, the S-Corporation may not have more than one class of stock (although differences in voting rights amongst the stock is permitted).
There are further limitations placed on the types of corporations- S-Corporations cannot be ineligible corporations. Ineligible corporations include an insurance company subject to tax under subchapter L of the Internal Revenue Code, domestic international sales corporations, and other ineligible corporations.
Electing S-Corporation Form
The S-Corporation entity or opting to be taxed as a pass-thru entity offer several benefits to the shareholders, particular the elimination of the double taxation present in a C-Corporation. The limitations placed upon S-Corporations, though, can be cumbersome. Often, business owners run into problems with having too many shareholders, desiring more than one class of stock, or having a nonresident alien shareholder. These limitations become more problematic as the business grows.