An S-Corporation Isn’t a Type of Entity
As a business attorney, I am often asked by founders launching a new business or startup if they should form an S-corporation. They often approach me for advice while deciding between a C-corp and an S-corp (or between an LLC and an S-corp).
One point of clarification, which is a bit technical, although helpful for understanding how to navigate the world of law and tax, is that S-corporations are not formed. Contrary to popular belief, an S-corporation is not a type of entity. Many entrepreneurs and startup founders think they need to decide between forming an S-Corporation (S-Corp) or a C-Corporation (C-Corp) or a limited liability company when they start a new business. But, that’s not true. You don’t form an S-Corporation by filing a Certificate of Formation or Certificate of Incorporation with the Secretary of State. When you file a Certificate of Formation/Incorporation to form a corporation with a Secretary of State, by default it is a C corporation (unless it’s a non-profit or public benefit corporation or something entirely different altogether). Again, at the point of time when you are forming a corporation, it’s not possible to form an S-corp.
Quick aside, you can elect to change the default tax classification of an LLC (from either a sole proprietorship (for tax purposes, not legal purposes!) or partnership to taxing the LLC as a C-corp or S-corp). LLCs are very flexible, including in how you elect to tax them. I realize the distinction between the legal structure of an entity and its tax classification can be a bit confusing, although it’s an important distinction for startup founders and other business owners to understand.
Back to your options at the time of forming the entity … the main choice startups make is to form either an LLC or a C-corp. There are other types of entities and business structures, including public benefit corporations, limited liability partnership, and low-profit LLCs. However, in my law firm (I am a business attorney in Texas), 80%+ of the formations I handle are either corporations or LLCs. For more about deciding between an LLC and a corporation (by default, a C-corporation), read 4 Things To Know When Deciding Between an LLC or Corporation.
What is an S-Corporation?
A S-corporation is a type of tax classification (it’s also called a “Subchapter S election” after the section of the IRS Code that talks about the tax treatment of S-corporations). A Subchapter S election is a type of request you make to the Internal Revenue Service (IRS) to change the method of taxation of a corporation or limited liability company. You (or your startup’s lawyer or accountant) contact the IRS and choose to designate your corporation or LLC as an S-Corp by filing Form 2553, Election by a Small Business Corporation. This is a tax filing and it is done entirely through the IRS (not the Secretary of State).
Talk to your business attorney and CPA about electing to be taxed as an S-Corporation after you form the entity. To give you some perspective for that conversation, let’s dig into the benefits of S-Corporations.
Double Taxation: The Bane of C-Corporations
The IRS describes double taxation as being taxed on both corporate earnings and then again at the individual stockholder level when corporate earnings are distributed to stockholders as dividends. Why does this happen? Well, corporations are treated as separate legal entities from individual owners (i.e., stockholders in a corporation, or membership interest holders in the case of an LLC), so the IRS, in taxing both the corporation on its earnings and stockholders on any dividends received from those earnings, is essentially taxing two separate entities or persons (“person” is the word used by lawyers when they are referring to entities and individuals). Or, so that’s how the argument goes. There is a lot of debate around this topic, which you can read about on Investopedia. The bottom line is that having a corporation (or a limited liability company taxed as a C-corporation, although that’s a rare combination and I can’t recently recall seeing it in my practice as an Austin-based business lawyer) can result in being taxed twice – once on the earnings of the business and once on distributions from the business to the owners.
“I like to pay taxes. With them, I buy civilization.”
-Oliver Wendell Holmes (former Supreme Court justice)
However, there’s a way to get around the double taxation issue even if you initially form a C-corporation. You can do it by electing for S-Corp treatment through the IRS if it is available for your entity and depending on the specifics of your enterprise (see below – Rules to Qualify to be an S-Corporation).
When your business (whether it is a corporation or LLC) makes an election to be taxed as an S-Corporation, any corporate income, losses, deductions and credits are passed through to the owners for federal tax purposes. After the election, stockholders in an S-Corp must report the flow-through (also called “pass-through” by professionals) of income and losses on their personal tax returns, and they are taxed at their individual income tax rates (the income and losses are reported on forms called K-1s). This allows S-Corps to avoid double taxation on corporate income.
NOTE: The Subchapter S election isn’t a silver bullet for all corporate gains and income. S-Corps are still responsible for paying taxes on certain built-in gains and passive income. And, as I mentioned, there are rules (hey, it’s the government, it’s ALL ABOUT rules!).
Now that you have the background on what a S-Corp election means and why certain businesses do it, the real question is whether this is the right decision for your corporation or LLC – should you elect to be taxed as an S-corp? That depends on a number of considerations, two of which I discuss below.
Rules to Qualify For S-Corporation Taxation
When you are considering transitioning your C-Corporation or LLC to be taxed as an S-Corp, you must first determine if your corporation or LLC meets the IRS requirements for qualifying for S-Corporation status. While you should consult with your accountant and corporate attorney for a specific determination on whether your business qualifies for S-Corp tax treatment, here are the general requirements for S-Corp treatment:
- Your entity must be a domestic corporation (i.e., incorporated in a state in the U.S.)
- Your entity may have only certain types of shareholders, including individuals, certain trusts and estates. The stockholders in your entity may not be partnerships, corporations or non-resident alien stockholders (most LLCs can’t be shareholders in a S-corp either)
- You can only have 1 class of stock
- You can’t have more than 100 shareholders
- You cannot be an ineligible corporation (e.g., certain financial institutions and insurance companies, among others).
The S-Corporation Advantage: Lower Personal Income Taxes
If you meet the requirements above, then you at least have the option to elect for S-Corporation tax treatment. But, that’s where the second consideration comes into play – will electing for S-Corp treatment reduce the amount of taxes you have to pay? After all, the primary reason why a business owner would elect to have their corporation or limited liability company taxed as an S-corporation is to save money on taxes. Otherwise, they’d stick with the basic setup – the default tax structure in a corporation (which, again) is corporate double taxation) or LLC (which, by default, is partnership taxation if there are multiple members and sole proprietorship taxation if there is only one member (the IRS treats a husband and wife as one member for this purpose).
To decide this question (will electing S-corporation tax classification save you money on taxes personally?), we need to start with something a little more fundamental – what counts as “compensation” for federal income tax purposes?
The IRS defines “compensation” as “earned income.” Earned income is anything you make from working for someone or from running a business.
The IRS wants to categorize income as compensation because compensation is used to pay for things like payroll taxes and self-employment taxes. For a W-2 employee, payroll taxes (these are taxes arising under the Federal Insurance Contributions Act (FICA) cover the following taxes:
- Social Security (12.4% for any dollars earned up to a base limit ($127,200 in 2017 – see https://www.irs.gov/taxtopics/tc750/tc751) with half paid by the employer)
- Medicare (2.9% with no cap, with half paid by the employer)
- For W-2 employees who earn over $200,000 per year, there is an additional 0.9% Medicare surtax.
Adding up the numbers (not including the surtax) yields a total of 15.3% in payroll taxes, approximately half of which are paid by the employer. For a self-employed person whose money is distributed from an LLC taxed as a partnership or sole proprietorship or dividends from a C-corporation, this type of compensation is typically subject to tax at the rate of … wait for this, 15.3%! (note that historically members in an LLC who weren’t active in the management of the LLC haven’t had to pay self-employment tax on their distributions, however the IRS is more aggressively going after members (owners) and challenging their active vs. passive status).
Imagine that! The government got their tax money one way or the other – 15.3% through a combination of employee and employer taxes out of a W-2 employee’s pay check or 15.3% in self-employment tax.
But, what about profits that are distributed to stockholders of an LLC or C-Corp that elects to be taxed as an S-Corporation, their so-called “distributive share” – how are those profits taxed at the personal level? This question gets at the heart of the reason why an S-corporation can lead to tax savings. Unlike self-employment income and W-2 income, the profits from an S-corporation are not usually considered compensation, which means these types of profits are classified as ordinary income and are only taxed under federal income tax and state income tax. They are not subject to self-employment tax. And, since S-corporation profits are not distributed through the W-2 payroll process, they are not subject to FICA taxes.
Illustrating the Possible Tax Savings of S-Corporation Taxation
Let’s illustrate the tax savings possible with S-corporation tax treatment by looking at how a person’s income tax situation might vary depending on the source and structure of their income. The example below assumes a person generates available income (gross earnings) of $100,000 per year and is subject to 30% in federal taxes and no state income tax (in Texas where I am a business attorney, we don’t have a state income tax. If you’re in a state with a state income tax, you are welcome to come here! Seriously, for our example it doesn’t matter much if there is or isn’t a state income tax – the illustration is just as insightful either way).
* An S-corporation owner who is active in their business, must pay themselves a reasonable salary. See below.
That’s $9,180 more income by simply sending a letter to the IRS (okay, that’s a bit understated). That’s 16.8% more income! Sounds incredible, right?
S-Corporation Owners Must Pay Themselves a Reasonable Salary
There is, however, one large caveat for this incredible deal. If you elect for your LLC or corporation to be taxed as an S-Corp, then you must pay reasonable compensation to a stockholder-employee (which includes yourself as CEO) for services provided to the entity before non-wage distributions may be made to that stockholder-employee. And, your salary is paid as W-2 income and subject to 15.3% in FICA taxes. The IRS may even go in and reclassify distributions from “dividends” to “wages,” and then subject those wages to employment taxes. You can read more about this caveat, as well as a few additional federal income tax wrinkles, here on the IRS website.
The obvious question is “what constitutes a reasonable salary” for S-corporation owner purposes. There are lots of cases out there between the IRS and business owners. To read a few of them, visit S Corporation Shareholder Compensation: How Much Is Enough?.
A New Carve out to the S-Corporation Tax Benefit Scenario
In 2013, Congress passed Section 1411(c)(2)(A) of the IRS Code in connection with the Affordable Care Act. This new provision applies a 3.8% tax on the lesser of “net investment income” or “modified adjusted gross income” above certain thresholds. Net investment income includes gross income from a business to a taxpayer who does not personally materially participate in the business (within the meaning of Section 469 of the Code, which has a bunch of tests, including the 500-hour test that says a taxpayer who works more than 500 hours in the business is materially participating in the business) and businesses involved in trading financial instruments and commodities. For a shareholder who isn’t active (who does not materially participate) in an S-corporation, some of the savings from passing through distributions will be recaptured by the IRS.
Talk to Your CPA and Business Attorney
You can make the S-Corporation election by filing Form 2553 either:
- No more than two months and 15 days (75 days) after the beginning of the tax year the election is to take effect (for a new entity, the tax year begins the date the entity begins doing business, acquires assets or issues shares, whichever occurs first); or
- After two months and 15 days (75 days total) into the tax year preceding the tax year when the S-corporation will take effect. For a company whose fiscal year ends on December 31, this means if they file the S-corporation election between March 16 and December 31 of a given year, the election will take effect on the following January 1.
If you miss the deadline to file an S-corporation election, the IRS may forgive you for being late and let you file still. Talk to your accountant about how to get this done (not an easy DIY job).
You also need to obtain the appropriate internal approvals from your Board of Directors and/or stockholders (in a corporation) or members or managers and/or board of managers (in a limited liability company).
Before you elect to be taxed as an S-corporation, speak to your business (corporate) lawyer and a CPA. This is easy territory to make a mistake and the stakes are significant. This is especially important if you currently have a C-corp because there are many traps for the unwary, including freezing net operating loss and credit carryforwards, which can’t be used by the s-corp.
Technology Startups Should Generally Avoid S-Corporation Status
As a business attorney in Austin, Texas, I represent a lot of technology startups. And, I nearly always advise my startup technology clients to not file an S-corporation election.
Venture capitalists and many other institutional investors prefer not to own equity interests in a pass-through entity (where income flows through directly to the owners). They prefer to own shares of stock in C-corporations. There are a couple reasons why this is true. One is that the venture capitalists don’t want a situation where they are allocated income (and taxed on it) without receiving distributions of cash to offset the taxation – this is referred to as phantom income. It can happen in pass-through entities.
Also, stockholders in pass-through entities may be subject to taxation wherever the entity does business. If the entity does business in many states, that can increase the administrative and compliance burden on the stockholders. Also, S-corporations are limited in many ways, including that they can only have one class of stock. Most venture capitalists purchase preferred stock while founders retain common stock – right there we have two different classes of stock. So, if you are intend to seek venture capital, form a C-corporation in Delaware (for more about this visit 4 Things To Know When Deciding Between an LLC or Corporation.
Because there can be challenges removing an S-corporation election once you place it on a company, be cautious in doing so. Only make the election if you know you are going to keep the S-corp status for many years. And, if you think about it, the S-corporation election is unnecessary for most quickly growing technology companies because they don’t show a whole lot of income usually. Their earnings are reinvested into the business to grow – this is typical. When that’s the case, the second layer of taxation isn’t the burden it otherwise would be if the business generated a lot of net income.
LLC Owners Electing S-Corporation Taxation Beware of Multiple Classes of Equity and Other Issues in Your Operating Agreement
Most limited liability company operating agreements contain language drafted for partnership accounting, including language that talks about substantive or alternative economic effect. These provisions are inapplicable to an LLC taxed as an S-corporation. In fact, they can be worse than inapplicable, they can be problematic, causing the S-corporation election to fail. The reason is based on Treasury Regulation §301.7701-3(c)(1)(v)(C), which states the election is only valid if “the entity meets all other requirements to qualify as a small business corporation under section 1361(b).” One of the requirements of 1361(b) is that the company has only one class of stock. Any varying rights among stockholders (or, in the case of limited liability companies, among the members) may be deemed to constitute multiple classes of stock. Because some of the partnership accounting provisions in a typical operating agreement can lead to disparate treatment among similarly-situated members, the IRS can argue there are multiple classes of equity. This is a confusing topic. If you want to dive deeper into it, visit Partnership Provisions in LLC Operating Agreement Renders S Election Invalid.
The repercussions of a failed S-corporation election (called a defective election) can be major, including reclassification of your income and the assessment of retroactive taxes. Fortunately, the issue is easily handled by talking to your business lawyer and asking them to review your operating agreement and make any necessary changes at the time you elect to be taxed as an S-corporation.
If You Remember Nothing Else About this S-Corporation Article
If you are still confused or don’t trust yourself to remember all the details I gave you in this article, remember these few things:
- An S corporation (also called a Subchapter S Corporation) is not a type of entity. It is a tax election (designation) that you obtain by filing a piece of paper with the IRS.
- You can elect to tax either an LLC or a corporation (by default, a C Corp) as an S-corporation.
- S-corps have lots of rules, so talk to your attorney or accountant before making a Subchapter S election. You will use only a tiny portion of your future tax savings to get solid advice to keep you out of any trouble.
- If you are launching a business/startup that expects to raise venture capital (institutional investment), you probably shouldn’t elect for S corp taxation.
How much can you save from S-Corp election status? This calculator can help answer that question.
How to Reach This Business Lawyer
I am a business (corporate transactional) lawyer with offices in Austin and Houston, Texas (and also licensed in Delaware) and helping business clients throughout the U.S. If you have questions about S-Corporations or other issues regarding formation of entities, taxation and structure, or other corporate law questions, give me a call at 512.888.9860.
Author: Brett Cenkus
Brett Cenkus is a business attorney with 18+ years experience based in Austin, Texas. He has worked with a variety of businesses and has clients throughout Texas as well as many technology clients throughout the United States. Brett is a Harvard Law graduate with a sharply seasoned mind and an entrepreneurial heart. As a founder of 6 companies himself, he is especially passionate about helping startups succeed. In 2016 Brett was named the winner in the Individual category for RecognizeGood’s Ethics in Business & Community Award. He offers businesses solutions that are in sync with their culture, goals and values. You can learn more about Brett by visiting the About page on this website.