There are several ways that aspiring entrepreneurs can structure their new business. The most well known are the limited liability company (LLC), and the corporation. The basic corporation is what’s known as a C corporation, but there are also S corporations, named for Subchapter S of the Internal Revenue Code. A corporation takes on the S designation when it elects to pass income through the corporation and onto its shareholders; the corporation itself does not pay taxes on its income, but its shareholders do.
Why is this a desirable arrangement? It can help startups by reducing tax liabilities at a crucial time for the business’s development. In addition to income, losses also pass through to shareholders (in many cases, startup employees); these losses can be offset against income received from the business (and other types of income) in calculating the amount of income tax owed. In addition, as a corporation the S structure allows shareholders to receive dividends, which are then taxed at the more favorable capital gains rate.
While these are definite benefits to having S status, there are other caveats that should be considered when deciding whether to make the S election. Because of the corporate form, S corporations need to adhere to stricter legal formalities than an LLC (such as paying state report fees, creating corporate bylaws, issuing stock, and more detailed recordkeeping). S corporations also have limitations on issuing stock that their C counterparts don’t; there may only be 100 shareholders per S corporation, and only one class of stock can be issued. This can complicate the process of dividing stock options between investors, since there is no way to allocate different types of dividends or distribution rights that different investors might want. In addition, the IRS watches S corporations more closely, since shareholders can receive both dividends and a salary; the IRS will need to ensure that payments made to shareholders are accurately represented.
However, whether a business should make the S election depends on the needs of the business and its members. Other benefits available to S corporations include transferability of shares (which can’t be done in an LLC), and the corporate structure (compared to the more partnership-like LLC); these should all be considered in deciding what sort of organization will suit your business best.