Is an S Corporation Right For Your New Business?

The pros and cons of S corporation business structures

Q.   What should I know about S corporations? How are they different from C corporations and LLC's?

A.   Decisions. Decisions. Decisions. When entrepreneurs make the big decision to leave a 9 to 5 job, they often say they made the leap for the opportunity to be the top decision maker. At last, they can devote more of their work day to their innovative pursuits.

Unfortunately, the entrepreneurial dream doesn't always match up to startup reality. During their first months of freedom, entrepreneurs find they are consumed with a wide range of boring, administrative tasks. It's why discouraged readers ask, "When does it get fun?" "When will I have a chance to make a difference?"

Call me odd, but I do think selecting the structure of a startup business is interesting and fun. It's an entrepreneur's first big decision with strategic consequences.

Since 1997, S corporations have been the most popular form of corporate tax return filed with the IRS. There are a number of reasons why over 3 million US companies elect S corporation status instead of filing as a standard C corporation.

Like standard C corporations, S corporations shield owners' personal assets from unpaid debts (provided they are not personally guaranteed) and other business liabilities. Businesses that operate in traditionally litigious industries such as heavy manufacturing, food or consumer products often seek the limited liability benefits of a standard C corporation, S corporation or a limited liability company ("LLC").

Perhaps the best part about an S corporation is its favorable tax status. With the exception of taxes on certain capital gains and passive income, an S corporation is exempt from federal income tax. This means that most S corporation profits and losses are "passed through" to the individual shareholders.

Owners of small profitable companies may be able to save thousands of dollars in taxes, providing more money for business expansion. Of course, this added cash flow can also be paid to shareholders in the form of dividend distributions.

Here's another fine point about corporate taxation. Dividend distributions to shareholders of standard C corporations are not deductible for federal income tax purposes. As such, the IRS collects a double tax on dividends: once at the corporate income level and then again when individual shareholders report dividend income on their personal tax returns. Organizers of S corporations can avoid this nasty double tax hit.

Sounds great doesn't it! But S corporations may not be right for venture capital bound businesses because of the "one class of stock" requirement. Angel investors and venture funds generally insist on receiving a separate "preferred" class of stock with benefits over common shareholders.

There are other restrictions too. Whereas standard C corporations and LLC's can have an unlimited number of shareholders, S corporations are limited to 75 shareholders. These shareholders must be U.S. residents, estates or certain trusts and partnerships. Ambitious entrepreneurs who receive equity funding from international corporations or investors won't meet IRS criteria.

S corporations are perhaps most viable for businesses that are organized by one or a small number of individuals. In addition to the other tax-saving benefits, S corporations have been used to reduce owner-manager employment taxes. Instead of paying compensation in the form of a salary, owner-managers paid themselves in the form of dividend distributions to avoid some payroll taxes. To close this loophole, the IRS now requires owner-managers to pay themselves a "market salary" before distributing dividends. Still, owners of very profitable S companies can save money by dividing up their compensation.

So, what is the best structure for your business? As the founder of your new enterprise, the joy of making the decision is all yours.

Do you want to find reliable investors for your business? Write to Susan at susan@takecommand.org for great funding references and tips designed for startup entrepreneurs, sole proprietors and fast growth companies.

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