Ain’t No Party Like An S-Corp Party
WHY S-CORP MAY BE YOUR BEST CHOICE, WE’RE GONNA SHOW YOU HOW…
Remember this song? Of course you do! (It will be stuck in your head for the rest of the day. You’re welcome.)
Taxes are a huge concern for most entrepreneurs. We unpacked why LLC’s are the premier entity choice for starting your business in this post here. But let’s be honest, detailed considerations may be needed to maximize your company’s structure. Having your company be taxed as an S-Corp does have tremendous tax benefits under certain limited scenarios. It’s true. S-Corps are unique but we want to make sure if you show up to the S-Corp party you will still have fun.
As we have discussed, an S-Corp is a flow through taxation structure due to an election made with the IRS. Which means the S-Corp must allocate its taxable income to the individual stockholders according to their ownership stakes in the company. Although, taxable losses at the entity level may be used to offset personal taxable income of the individual stockholders, but only to the extent of the tax basis of their interests in the entity. In simple terms, the Tax basis is the “cost” to purchase their shares.
Choose your own adventure.
There are some big questions you need to ask when deciding whether or not to be an S-Corp, just make sure you are writing the story that ends in a happily ever after. Here are some of those questions:
#1 How do I plan on financing my company’s growth?
If you plan to use outside sources of sophisticated capital such as angel investors or venture capital funds the structure and type of investments these groups usually prefer to make cannot happen if you are taxed as an S-Corp.
There are two main reasons.
First, with rare exception, only individuals can own an S-Corp not investment funds or companies.
Second, an S-Corp can only offer a single class (types include Common or preferred) of share in the company, which means that you cannot have different types of voting or distribution of profit. Angels and VCs like to invest in growth companies in ways that make an S-Corp undesirable and they will often require you to convert to being taxed as a C-Corp.
Make sure you have a solid plan for funding your company before you decide which entity works best. Raising capital from investors leads to a No for an S-Corp.
#2 Will I be taking a salary as the owner-operator of the business?
If you are going to build a service company and take a salary as the shareholder and/or officer of the business, you are going to get crushed on self-employment taxes if you are taxed as a partnership (i.e., sole proprietors, partnerships, and LLCs). S-Corps were primarily invented to help business owners who receive a salary keep their self-employment taxes down. This is the primary tax benefit of an S-Corp and the only reason Briefcase attorneys ever recommend their use.
Self employment taxes are a huge expense for a small founder run company. S-Corps can reduce that tax burden!
#3 Do I want to incentivize my team with equity in the company?
If you are going to be an S-Corp and you award your executives with equity in the business, they have to own the same type of stock as the founders and they get the same rights to voting and profit. One way many founders get around this hurdle and still reward their top folks is to give them cash bonuses and higher commissions for great performance. But remember, people like to take ownership in their work and giving ownership is a great way to motivate your team. There is simply something magical about equity and we cannot overstate the impact it often has when you are trying to incentive your executives to reach new heights of performance.
Remember, S-Corps create some complexity to protect the management team’s control when offering equity to employees. Consider all the outcomes for using equity. Are there alternative bonus and incentives you can offer?
Does this look like you and your company?
Briefcase knows there are tons of different opinions out there about LLC v. S-Corp. Here’s standard fact pattern we think everyone can agree justifies the company being taxed as an S-Corp. Using the questions above can help to forge your own adventure with a little more predictability and ensure that you are making the most of your new entity structure!
Single Owner, Self Funded, Service Company, with only a few employees.
Tara is starting a sleek new creative agency that offers its customers trendy and affordable web-based marketing tools. She will be working for the company full time as its CEO. She has no partners other than her uncle who loaned her $50,000 to get started. She really wants to build up the company with its own organic cash flow and doesn’t intend to ever seek VC money to grow her business. The employees she intends to hire will get cash bonuses as incentive to work hard.
Help? Yes, please!
We created Briefcase to be the resource for you when trying to decide whether you want to be an S-Corp. Briefcase’s attorneys study and evaluate these issues regularly and would love to help you make the right decision and provide all the documents you need to get organized!
Questions: Do your answers to the 3 questions above make you an ideal candidate to be an S-Corp? Could using an S-Corp stunt your future plans? What’s your main concern when choosing a tax status for your company?