The S corporation is a corporation, and for state law purposes is identical to a C corporation. The only difference is in the federal taxation of the business. S corporations, like LLCs taxed as partnerships, are pass-through entities, meaning that the profits and losses of the business pass through to the owners of the business. The S corporation, even if it only has one owner, does have to file a tax return, but it is an informational return. There are a number of limitations to qualify a corporation as an S corporation for tax purposes, however:
- There can only be one class of stock. Investors will often want a separate class of stock, called preferred stock, which will be separate from the class of stock owned by the founders of the business.
- There can only be US natural persons as stockholders. Foreign individuals, LLCs, corporations, trusts and other entities as stockholders are not allowed.
- There can be no more than 100 stockholders. This may not be a concern for quite a while, but it is a limitation to be mindful of.
The S corporation can be a great way to start out when you will meet the S corporation rules and are not sure if you will want to raise outside capital or not. One class of common stock is suitable for the founders and employees of the corporation. Your corporation will be able to issue equity incentives with favorable tax treatment, and your corporation would not need preferred stock unless and until it raises outside capital. The founders of the business can enjoy the benefit of pass-through taxation during the initial phase of the business, and, unlike a LLC, the business will not have to convert its structure in order to raise outside capital.
This article originally appeared on Venture Docs, an online platform for automating the creation of important legal documents for startup companies, investors, crowdfunding portals and attorneys.
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