In the early stages of running a company, many people should consider setting up their businesses as a C Corp with an “S” election, at least until a specific investment/investor is on the table. An S corp is subject to certain restrictions, which could be undesirable limitations such as the requirement that they only have one class of stock. Thatsaid, it is a great structure in the beginning stages of a company as it allows the founders and any other shareholders to be taxed as a partnership. For instance, like a partnership and unlike a regular C corporation, an S corp is not a separate taxpaying entity so it avoids double taxation. Most of the tax attributes of an S corporation (income, losses, deductions, and credits) are passed through, proportionately, to the shareholders, who report and pay any tax due on their individual income tax returns. Deductible losses are limited to the shareholder’s basis in the stock, plus any loans made to the corporation. As with partners, S corporation shareholders are limited by the at-risk and passive activity loss rules of the Internal Revenue Code.
To be more specific about the restrictions related to S corporations, however, founders should note that to qualify as an S corporation, the following requirements must be met:
- The number of shareholders must be no greater than 100 (husband and wife are ordinarily treated as one shareholder);
- Shareholders must be individuals (excluding resident aliens), estates, certain enumerated types of trusts, qualified subchapter S subsidiaries, and certain exempt organizations;
- An S corporation may not be a financial institution that uses the reserve method of accounting for bad debts, an insurance company, a corporation that has elected special tax treatment and operates in Puerto Rico or other United States territorial possessions, or a Domestic International Sales Corporation (DISC) or former DISC; and
- An S corporation may not have more than one class of stock (neither differences in voting rights nor “straight debt” instruments create a second class of stock).
All shareholders, including subsequent shareholders, are bound by the S corporation election. The election may be made at any time during the preceding taxable year or at any time during the taxable year and on or before the 15th day of the third month of the taxable year. If the election is revoked or terminated (inadvertent invalid elections and terminations), a corporation generally may not elect S corporation status again for a period of five years.
A corporation that has a valid election in effect for federal purposes will be an S corporation under California tax law, and its shareholders will be shareholders of an S corporation without regard to whether the corporation is qualified to do business or is incorporated in California.