Subchapter S: Some Myths, Realities and Practical Considerations
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I have often had entrepreneurs tell me with great
confidence that they either do or do not want to set up their venture as a
Subchapter S corporation. Equally
often when I ask them why they want to take that course of action I find they
don't really understand what is involved.
What is a Subchapter S Corporation?
A Subchapter S corporation is a corporation, which meets the requirements
for and has made a proper election to be taxed under Subchapter S of the
Internal Revenue Code. Although its taxation is a creature of the tax code it is not
a corporation, which is organized under the Internal Revenue Code. This seems to be a popular misconception among entrepreneurs.
Why Elect Subchapter S status?
The primary perceived benefit is one layer of tax.
A corporation like IBM is taxed under "Subchapter C" of the
Internal Revenue Code. IBM pays
taxes on its net profits and then the IBM stockholders pay taxes when the
profits are paid out to them. In
contrast, in a Subchapter S corporation the corporation's net profit or net loss
is deemed distributed to the stockholders, who have to include it on their
individual tax returns whether or not they actually receive cash.
It used to be a relative no brainer to elect S if you
qualified. The highest corporate
rates were higher than highest individual rates.
So if the corporation elected Subchapter S status the overall situation
resulted in less current tax. After
the tax changes in the early Clinton years, the highest individual rates (in the
40% range) are now higher than highest corporate rates (generally 35%) and as a
result the venture (corporation and stockholders combined) may actually pay more
currently if the venture is profitable and elects S status.
Now you have to look at the venture's likely exit strategy.
If the company can be sold through an asset sale in a few years then with
a cash flow model you can determine the net present value of paying
incrementally higher taxes currently in order to pay only one layer of tax on
"big hit" sale at end, assuming the tax rules don't change in the
interim. If the exit strategy is a tax-free stock-for-stock
acquisition of your company by a public company then it might not make sense to
have the stockholders pay a larger current tax on profits. However, for most high tech growth companies involved in
product development there may not be any net profit during the development stage
so being an S Corporation will not create a current tax payment situation.
With one layer of tax, losses as well as profit flow
through. There are a number of
complex rules about how those losses can or can't be used currently to offset
other income of the stockholders. When
all is said and done your outside private investors will most likely not be able
to use their share of the losses currently and the only time the
Founders/management team will effectively be able to use the losses currently is
if (a) they have made actual cash investment in the venture, (b) they own a
large enough percentage of the venture so that the losses allocated to them are
useful, and (c) they have other income (e.g. a working spouse) to use the losses
The net result is that for most high growth technology
ventures the primary benefit to Sub S status is to avoid two layers of tax on
sale of the venture in an asset sale transaction.
Still this is useful.
Becoming a Subchapter S Corporation.
So how does a corporation receive the benefits of Subchapter S status?
First an S corporation must at all times qualify.
It can have no more than 75 stockholders who in general must all be human
beings. A few special types of
trusts are permitted as stockholders but you cannot have any corporate
stockholders, partnership stockholders etc.
Because of this, most S corporations lose their S status when venture
capital firms invest. No
stockholder can be a "nonresident alien"- e.g. an S corporation cannot
have as a stockholder a French citizen living in Paris. For all practical
purposes only foreigners living in the United States and having "green
cards" will meet the resident "alien" test.
The corporation must have only one class of stock (although two or more
classes are allowed if the only difference between the classes is in voting
Second, the qualifying corporation must elect to be
taxed under Subchapter S. In general to be effective for a year the election
must be filed with the IRS on or before the 15th day of the third month of the
taxable year. So for example, a
corporation formed on June 1, 2004 would have to file the election by August 15.
The election is a simple one page form that must be signed by all
stockholders. This creates a
practical problem if the stock ownership has not been worked out or if the
percentages are agreed but the stockholder agreement issues haven't been
finalized. Once Subchapter S status
is elected you can switch back to regular Subchapter C status but you can't
flip-flop back and forward and there are a number of technical rules which
Some Practical Issues.
With Sub S you are more involved with your investor stockholders' tax
situation. Every tax season you
have to supply them with "K-1"s reports so they know how to treat
their investment on their tax returns. If
you don't get these out in time for April 15, your stockholders will have to
file for extensions for their returns or file amended returns.
Some people don't like loose ends and will be annoyed if you delay their
April 15 filing schedule. With some
limited exceptions a Subchapter S corporation must have a calendar tax year.
This means that you will be dealing with your accountants during their
busiest season which may result in extra costs or the foregoing of discounted
billing, e.g., some accountants give lower rates to companies who have work that
does not need to be done during the "peak season".
In addition there is some level of general extra expense involved in
trying to work within the Subchapter S rules.
Alternatives to Subchapter S.
It is possible to achieve the single layer of tax through the use of a
partnership form of doing business. However
there is potential personal liability on the part of the partners even if the
limited partnership form is used and there are some operational problems in
running a business in partnership form. Another
option is to set the business up as a "limited liability company",
which can be structured like a partnership to give single layer of tax treatment
and provides limited liability to the owners of the business.
However, Massachusetts is one of only a handful of states that doesn't
recognize the limited liability company form of doing business.
So for our Massachusetts readers, you don't need to know about this yet,
however, you may want to call your state senator or representative and ask him
or her why the state that started the American Revolution is so far behind on
this one. [Note: Massachusetts has
now adopted the LLC form- see the column "Is An LLC For Me?"]
DISCLAIMER: This column is designed to give the reader an overview of a topic and is not intended to constitute legal advice as to any particular fact situation. In addition, laws and their interpretations change over time and the contents of this column may not reflect these changes. The reader is advised to consult competent legal counsel as to his or her particular situation.
Copyright 1994-2005, Joseph G. Hadzima Jr., All Rights Reserved.