S Corporation

An S Corporation is a US federal tax election that allows a domestic corporation or LLC to pass profits and losses through to shareholders. Named after Subchapter S of the Internal Revenue Code, the election is not a separate entity type but a tax classification that avoids the double taxation C-corporations face. S-corp status is subject to restrictions on shareholder type, count (100 maximum), and stock structure (one class only) that make it largely incompatible with venture-backed startups. It is a popular structure for small businesses with US-citizen owners and incompatible with the cap-table realities of most institutional fundraising.

The restrictions that disqualify most venture-track startups: maximum 100 shareholders (institutional rounds quickly exceed this through VC funds, syndicates, and employee equity), only US citizens and US residents can be shareholders (immediately blocks any foreign investors), only one class of stock allowed (S-corps cannot have preferred stock, which is the entire structure of venture financing; this restriction alone disqualifies S-corp status for any company taking institutional capital), and certain entity types cannot be shareholders (most trusts, partnerships, corporations, and IRAs are barred, blocking common VC structures). The tax advantage that does work for small businesses: pass-through taxation (profits and losses flow to shareholders' personal returns; no entity-level federal tax), combined with avoiding self-employment tax on distributions (S-corp owner-employees pay themselves a "reasonable salary" subject to payroll tax, and take additional profits as distributions free of self-employment tax; this can save real money for profitable small businesses). The form to elect S-corp status: IRS Form 2553, filed within 75 days of incorporation or 75 days into a new tax year for an existing entity. The reality for venture-backed startups: S-corp election is almost never the right answer; Delaware C-corp from day one fits the funding path. The reality for cash-flow-positive small businesses: S-corp election can save tens of thousands of dollars annually in self-employment tax for owners who would otherwise operate as sole proprietors.

Ryan's Take

S-corporation is the tax-election answer for profitable small businesses with US-citizen owners, and the wrong answer for almost any venture-track startup. The single-class-of-stock restriction ends the conversation: VC investments use preferred stock, S-corps can't have preferred stock, so the moment you take a VC check, the S-corp election would terminate and you'd convert to C-corp anyway. Just start as a C-corp if you're on the venture path. S-corp is for a different kind of business: profitable, small, US-citizen-owned, no plans to raise institutional capital. That business is a real and good business, just not a startup in the venture sense.

What founders get wrong: Electing S-corp status because the pass-through taxation sounded appealing, then trying to raise venture capital and discovering the S-corp election will terminate automatically the moment a VC fund (which is not an eligible S-corp shareholder) acquires stock. Plan the entity structure around your fundraising path: S-corp for non-VC small businesses; C-corp for anything venture-track.

Related: [C Corporation] · [LLC] · [Delaware C-Corp] · [Incorporation]

FAQ

What is an S Corporation? A US federal tax election (named after Subchapter S of the Internal Revenue Code, not a separate entity type) that allows a domestic corporation or LLC to pass profits and losses through to shareholders for tax purposes, avoiding the double taxation that C-corporations face. Subject to significant restrictions on shareholder type and stock structure.

Why can't venture-backed startups use S-corp status? S-corps cannot have preferred stock (only one class of stock allowed), and venture investments use preferred stock. S-corps also cap shareholders at 100, ban foreign investors, and disqualify most trusts and corporations from being shareholders. Any of these restrictions alone disqualifies most institutional fundraising.

When does S-corp election make sense? For profitable cash-flow-positive small businesses with US-citizen owners and no plans to raise venture capital. The self-employment-tax savings on distributions can be tens of thousands of dollars annually. File IRS Form 2553 within 75 days of incorporation or 75 days into a new tax year for an existing entity.