Five Questions to Ask Before Forming an S Corporation

Running your business as an S Corp can have both advantages and disadvantages. This article discusses the 5 questions you should ask before making an S Corp your entity of choice.

Choosing to run your business as an S Corporation (S Corp) can have significant consequences. When forming (incorporating) an S Corp, there are five things in particular that you should think about before you file any official documents. This article assumes that you have already chosen a corporation as your preferred entity type (instead of a limited liability company (LLC), partnership, sole proprietorship, and the like), and would like the IRS to treat your corporation as an S Corp for tax purposes. For further information on how to pick the corporate entity type that is best for your particular situation, see Choosing the Best Ownership Structure for Your Business and S Corporations.

Will My Company be Eligible for S Corp Status?

The very first thing you should do before starting an S Corp is to determine whether or not your company will meet the legal standards required by the Internal Revenue Service (IRS). To operate your business as an S Corp, you must initially file your company as a regular corporation (C Corp) in your selected state of incorporation. To be eligible for S Corp status, the IRS requires that your C Corp meet certain specific criteria (S Corp Requirements), including, but not limited to, the following:

  • The company must be a domestic C Corp.
  • The company's shareholders (sometimes called stockholders in certain jurisdictions) must be individuals or certain allowable trusts and estates.
  • No shareholder can be classified as a partnership, corporation, or non-resident alien.
  • The company cannot have more than 100 shareholders.
  • The company can have only one class of stock.
  • The company cannot be an ineligible corporation (for example, certain financial institutions, insurance companies, and domestic international sales corporations are disqualified).

For further information regarding S Corp Requirements, see S Corporations.

Will an S Corp Give Me Tax Advantages?

The primary attraction of having the IRS treat your company as an S Corp rather than as a C Corp is more favorable tax treatment. The IRS treats a corporation as a person for federal tax purposes, which results in double taxation for its shareholders. In other words, the IRS will first tax the corporation as an entity, which reduces the remaining funds available (if any) for dividends to its shareholders. In addition to taxing the corporation at the entity level, the IRS will then also tax the corporation's individual shareholders on a personal level, resulting in double taxation for these individuals. In contrast, an S Corp benefits from pass-through taxation from the IRS, meaning that it will not be taxed at all at the entity level. However, depending on certain facts regarding your corporation's profits, losses, or other factors, it can still be possible at some point in the future that your company or its stakeholders would pay less tax under a C Corp structure. Luckily, you can always choose to go back to C Corp status by following the appropriate IRS procedures. For additional information on the potential tax advantages of an S Corp, see Why You Might Choose S Corp Taxation for Your LLC.

Do I Have a Tax Adviser?

Having an accountant or tax attorney advise you both during and after the incorporation process will allow you to best determine the potential tax benefits of electing S Corp status, based on the characteristics of the corporation and its shareholders. Once you have determined that taxation as an S Corp is the best choice for you, your adviser can also show you how to best take advantage of these tax benefits. Among other things, your tax adviser can inform you how to get your company's tax identification number and use it to open up a bank account. Your tax adviser can also give you a tutorial on what you can write off as business expenses for tax purposes and suggest how you should retain receipts and maintain your internal financial records. Your tax adviser can also guide you on how to make and record periodic cash distributions to shareholders, if applicable.

How do I Obtain S Corp Status?

To have the IRS treat your C Corp as an S Corp for tax purposes, you will need to make a Form 2553 tax election (Form 2553) when filing the company's federal tax returns. Your accountant or tax attorney can assist you with this process. Note that Form 2553 must be signed by all of the company's shareholders.

Will My S Corp be Attractive to Investors?

If you are contemplating having one or more investors help capitalize your business, or could potentially seek investors at some point in the future, then the S Corp Requirements could prove problematic. For liability, tax, and personal reasons, investors often make their investments through corporate entities (for example, C corporations, limited liability companies, or partnerships), not individually. Because the shareholders of an S Corp can only be individuals or certain allowable trusts and estates, this limits the universe of investors that would be available to you. Also, the S Corp Requirements would prevent any foreigners from investing in your corporation, unless you chose to abandon the company's S Corp status.

Investors typically want a return on their investment (ROI) as quickly as possible, and seek to contractually protect that ROI to the extent possible. For example, an investor may want to be fully repaid before any other shareholders receive distributions on their shares. Sometimes an investor will agree not to receive any ROI until the company is sold or liquidated, in which case no other shareholders would get a penny until the investor has been repaid in full. Investors typically want to further protect their ROI by demanding certain control rights regarding share transfers, corporate management, distributions, acquisitions, divestitures, liquidation, dissolution, and other matters. These investors' rights are usually memorialized in a shareholders' agreement (called a stockholders' agreement in certain jurisdictions), an investors' rights agreement, or some other similar document. Sometimes the investor requires the company to amend or restate its articles of incorporation (called a certificate of incorporation or charter in some jurisdictions) to reflect these rights.

One of the tools used by investors to grant themselves these ROI protections is to have the corporation create different classes (or series) of shares and then issue shares to the investors that have superior, or preferential, rights. The shareholders would then describe these classes of shares, and their respective rights, in the shareholders' agreement, the articles of incorporation, or both. Because the S Corp Requirements prevent the S Corp from issuing different classes of shares, it limits the options available for investors to contractually protect their ROI. As such, a tax adviser can either guide you through the added complexity of safeguarding investor ROI under a more restrictive S Corp structure, or, alternatively, assist you in converting your S Corp into a more flexible entity (for example a C Corp or an LLC).

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