S corporations can only have one class of stock; S corporations cannot issue preferred stock , for example. But this restriction can arise in other situations unexpectedly, and must be considered whenever issuing equity, including stock options or warrants.
- S Corporation vs LLC;
- S corporation advantages.
- Why Does Every Employee Want Stock Options? | Aprio.
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Flexibility of ownership. C corporations are not limited with respect to ownership participation. There is no limit on the type or number of shareholders a C corporation may have. S corporations , in contrast, can only have a limited number of shareholders, generally cannot have non-individual shareholders, and cannot have foreign shareholders all shareholders must be U.
More certainty in tax status. For example, a C corporation does not have to file an election to obtain its tax status. Single level of tax. S corporations are pass-through entities: their income is subject to only one level of tax, at the shareholder level.
C Corporations
This rule is also generally applicable on liquidation of the entity. Pass-through of losses.
Simplicity of structure. S corporations have a more easily understandable and simpler corporate structure than LLCs. S corporations can only have one class of stock—common stock—and their governing documents, articles, and bylaws are more familiar to most people in the business community than LLC operating agreements which are complex and cumbersome and rarely completely understood.
Vesting and Expanding Ownership
Traditional venture capital investments can be accepted. The issuance of convertible preferred stock by C corporations is the typical vehicle for venture capital investments. Venture capitalists typically will not invest in LLCs and may be precluded from doing so under their fund documents. Traditional equity compensation is available. C corporations can issue traditional stock options and incentive stock options. It is more complex for LLCs to issue the equivalent of stock options to their employees. Incentive stock options also are not available to LLCs.
Ability to participate in tax-free reorganizations. C corporations can participate in tax-free reorganizations under IRC Section Qualified small business stock benefits. LLCs cannot issue qualified small business stock. Self-employment taxes. Fringe benefits. C corporations have more favorable treatment of fringe benefits.
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State income tax return filing requirements. Each member of the LLC may be required to file a tax return in multiple states. This is not the case with C corporations. The flexible nature of LLCs makes them more complex. Partnership tax is also substantially more complex than C corporation tax. The relatively new nature of the LLC form and limited amount of case law make LLC transactions more complex and uncertain than their corporate counterparts.
Tax rates. Individual income tax rates can be higher than the highest stated corporate tax rates. Administrative burdens.
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Partnership tax accounting is more complex than C corporation accounting. An LLC has to withhold taxes on certain types of income allocated to foreign persons, regardless of whether distributions are made. C corporations are not subject to this requirement. LLCs are pass-through entities: their income is subject to only one level of tax, at the member level. Tax-free distributions of appreciated property.
An LLC can distribute appreciated property e. It is for this reason that entities formed to invest in real estate or the stock of other companies should not be C corporations. Tax-free formation. Tax-free capitalizations for C corporations must comply with the more restrictive provisions of the IRS to be tax free i. IRC Section although this is not usually a problem.
Sales of equity. S corporations can more easily engage in equity sales subject to the one class of stock and no entity shareholder restrictions, generally than LLCs.
For example, because an S corporation can only have one class of stock, it must sell common stock in any financing and this makes any offering simpler. An LLC will have to define the rights of any new class of stock in a financing, and this may involve complex provisions in the LLC agreement and more cumbersome disclosures to prospective investors. In addition, an S corporation does not have to convert to a corporation to issue public equity although its S corporation status will have to be terminated prior to such an event.
Legal Insight: The Perils Of Electing S Corporation Status
Traditional equity compensation available. S corporations can adopt traditional stock option plans ; in addition, they can grant incentive stock options. It is very complex for LLCs to issue the equivalent of stock options to their employees although they can more easily issue the equivalent of cheap stock through the issuance of profits interests—see below. Incentive stock options also are not available for LLCs. S corporations , just like C corporations , can participate in tax-free reorganizations under IRC Section Ease of conversion to C Corporation status.
It is typically easier for an S corporation to convert to a C corporation than it is for an LLC to convert to a C corporation. For example, upon accepting venture capital funding, an S corporation will automatically convert to a C corporation. For an LLC to convert to a state law corporation taxed as a C corporation, it is necessary to either convert the LLC to a corporation pursuant to a state law conversion statute, or form a new corporate entity to either accept the assets of the LLC in an asset assignment or into which to merge the LLC. Therefore, less thoughtful tax advisers might recommend electing S corporation status for an LLC or new entity as a means of obtaining more flexibility around optimizing the Section A deduction for high-income business owners.
In practice, an S corporation often provides little or no tax benefits relative to an LLC classified as a partnership, primarily for two reasons. First, the business might not generate sufficient residual income after payment of reasonable shareholder salaries to produce a meaningful tax benefit. Second, a properly structured manager-managed LLC can produce equivalent tax benefits. To reap the asserted tax benefits of an S corporation, the business has to generate sufficient taxable income to both a pay a reasonable salary to the owners and b still have a meaningful amount of positive residual taxable income allocable to the owners.
Appendix B: C Corps, LLCs, and S Corps — Angel Investing
This might happen, for example, because the owners set their salary higher than the minimum required level e. In other cases, deductions associated with expansion of the business might fully offset taxable income. Or the business might face unexpected conditions that frustrate its ability to achieve its income forecasts. There may be many other reasons why a business fails to produce a meaningful amount of positive residual taxable income, and for those businesses the promises of tax savings from electing S corporation status are illusory.
If the shareholder does not meet the relatively high standards for material participation, any self-employment tax savings will often be completely eliminated through imposition of net investment income tax on the residual income. Finally, even when the business produces meaningful positive residual taxable income and the shareholder materially participates in the business, the self-employment tax savings can be quite modest. Because half of the tax can be deducted for federal income tax purposes, the effective tax savings is typically less than those rates generally around 2.
Consequently, even successful businesses may find the asserted self-employment tax savings from electing S corporation status are negligible, particularly when measured in reference to the significant, and often inadequately considered, disadvantages of S corporation status as discussed above.