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What is an S corporation, and should my startup be one?

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An S corporation is an ordinary corporation that has filed an election with the IRS to be taxed like a partnership: the company pays no federal income tax, and its profit and loss pass through to the stockholders' personal returns. The election comes with conditions. The company must be a US corporation, have no more than 100 stockholders, all of whom are individuals, estates or certain trusts, none of whom is a nonresident alien, and have only one class of stock. A company that plans to raise money from a fund, sell preferred stock, or issue cheap common stock to employees fails at least two of those, which is why Arabella does not suggest an S corporation for a startup and does not make the election as part of a formation.

Who it is for

A profitable, owner-run business with a handful of US owners that distributes its profit each year and wants it taxed once. A consultancy, a practice, a family business. For that company the election saves real money, and the limits cost nothing because the company was never going to sell preferred stock to a venture fund.

Why it breaks for a startup

One class of stock means no preferred stock, so no priced round. It also means the company cannot sell founders and employees common stock at a fraction of what investors pay, since there is only one kind of stock and it has one price; the two-class structure is the mechanism that makes early equity affordable. The stockholder limits exclude funds, corporations and foreign founders. And stock issued by an S corporation is never QSBS, even if the company later revokes the election and becomes a C corporation, so the founders' shares lose the exclusion that founders' shares are usually best placed to use. A company that starts as an S corporation and raises a round has to terminate the election first, and the investors' lawyers will spend time confirming the election was valid every day it was in force.

If you have one already

The election ends the day the company stops qualifying, which issuing preferred stock does automatically, and the company is then taxed as a C corporation from that point. Losing the election by accident mid-year creates a messy split-year return, so a company that expects to raise should revoke it deliberately, with advice, before the round rather than let the round do it.

Whether a business that will never raise outside money should elect S status is a question for an accountant who knows its numbers. This article is about why a startup should not.

Written by the lawyers who built Arabella. This is legal information, not legal advice for your situation, and reading it does not make us your lawyers. For a real dispute or a high-stakes decision, talk to a licensed attorney. More questions.