Many of my clients are interested in forming S corporations instead of C corporations so they can save money on taxes. S corps are great, but the Internal Revenue Code imposes many requirements on S corps, some of which may trip up small businesses.
The requirement I get asked about most often is the restriction that all shareholders or members must share in one class of stock. This can be an issue for early stage companies that like to issue stock as compensation or reward for employees, but that don’t want to give out the exact same stock that is owned by the founders. Thankfully, the IRS only requires the stock to have identical rights to distributions and liquidation proceeds, not identical rights in voting. With this in mind, it is possible to provide your employees with non-voting common stock instead of voting common stock and not affect your S election.
S Corporations vs. C Corporations
An S corporation is a corporation or LLC formed under the laws of a state that then elects to be treated as an S corporation. The election is not made in the Articles of Incorporation or Articles of Organization of the entity, but typically made promptly after formation on form 2553, filed with the IRS. By electing S status, the entity can pass through all of its gains, losses, deductions and credits to its shareholders or owners so there is only one level of tax, at the respective owner’s federal tax bracket. In contrast, a corporation that does not elect S status, called a C corp, will recognize all the gains, losses, deductions and credit at the corporate level and at the shareholder or owner level, resulting in a double tax.
Requirements for S Corporations
Not all corporations or LLCs can qualify to elect S status. Among other requirements, the entity must:
- Be a corporation formed in the United States;
- Have only natural persons or certain trusts as shareholders (no corporate or partnership owners in an S corp);
- Have no more than 100 shareholders or members; and
- Have only one class of stock.
Employee Stock Plans/Equity Compensation
In order to incentivize employees, companies frequently issue stock options or restricted stock to employees. The stock is issued to attract talent, as a reward for performance or as an incentive to remain at the company, or all three. The thinking is that as a part-owner, the employee will be more invested in the company and work harder to achieve results that he or she will ultimately share with the other owners.
While the employer may recognize the benefit to having employees share in the profits of the company as an equity owner, employers tend not to want these same employees to have the exact same rights in the stock as the company’s founders. The easiest way to distinguish the founders from the employee-owners is to limit the voting stock to the founders or angel investors. This structure keeps management at the founder level, those who hold voting common stock, but profits and all economic ownership is shared among all the common-stock owners.
A company that desires the flow-through taxation benefits of an S corporation is not required to issue identical stock to all of its owners. The company can issue voting common stock and non-voting stock as long as the stock has identical rights to distributions and liquidation proceeds.