Learn about S-Corporations

S-Corporations are the newest corporate form available in the United State.   At Early Stage Legal, we really appreciate S-Corporations because they allow our clients to avoid double taxation (i.e., S-Corporations are pass-through entities) like an LLC but they are extremely easy to convert over to a C-Corporation (see Brad Feld's article on the topic).  Since C-Corporations are required by most equity investors, this creates a nice option for founders who are unsure whether or not they will need to raise equity capital in the future. 

The S-Corporation does have certain limitations and requirements relative to a C-Corporation:

  • S-Corporations must be domestic corporations (based in the US)
  • They can only have certain types of "allowable" shaeholders--basically US citizens and certain types of trusts and estates but not partnerships or corporations
  • They may have no more than 100 shareholders
  • They can only have one class of stock--no preferred stock
  • They must be an eligible type of corporation--certain kinds of companies like insurance companies are not allowed

Formation Requirements

S-Corporations require a fair amount of work to set up.  At Early Stage Legal, we can set you up with a lawyer-quality package at an unbeatable price.  A complete C-corporation package should include at least the following legal documents:

Liability

S-Corporations offer limited liability protection.  This means that shareholders and board members are generally not liable for the actions of the company, except for in extremely rare cases of "gross negligence." 

Governance

S-Corporations are controlled by a board of directors.  Generally there is a Chairman of the Board who calls the meetings to order and runs the meetings.  The board members approve high-level company actions like selecting the top managers of the company.  These managers, like the President and CEO, then run the company on a daily basis.  Directors have a duty to be careful in their decisions but they are protected from nearly all liability.  Directors also do not generally get involved in the day-to-day management of the company.

Management

Corporations must select at least a President and either a Secretary or a Treasurer at the time of formation.  Beyond that, the company's management can be created an organized based on the decisions of the Board of Directors as mentioned above. 

Taxation

Unlike the very similar C-Corporation, S-Corporations are not subject to "double taxation."   This means that the S-Corporation simply passes through earnings to the individual shareholders who then must pay taxes on that income on their personal income taxes.  This is one of the key benefits of an S-Corporation relative to a C-Corporation. 

Transferability of Equity

Subject to other legal documents that investors may put in place, shareholders may easily transfer shares of stock in corporations.  Generally shares are bought by investors who want to participate in the growth in value that occurs as a company grows rapidly.  These investors are hoping to sell their shares in a future "liquidity event" or buyout where a large company will buy their shares or where they can sell their shares on a public market after an IPO process.  Because investors want the management teams of their companies to remain hungry for a good outcome, they often put into place protective legal provisions that prevent management team members from selling their shares except during certain qualified

Capital Raising

S-Corporations are not ideal for raising equity capital because they are limited to only one classe of stock and most sophisticated investors want to invest in a second class of stock that is Preferred.  This means that the investor's class of stock enjoys special protections and benefits relative to the founders and common shareholder's stock.  However, it is possible for S-Corporations to convert into C-Corporations relatively easily if they decide to raise money from investors.

Ease of Maintainence

S-Corporations require the following maintenance:

  • The company generally has to have regular board meetings
  • The company generally has to have annual shareholder meetings
  • The company often requires that minutes must be recorded at board meetings

Ability to Convert to a Different Type of Entity

S-Corporations are designed to easily convert into C-Corporations.  Converting into other kinds of entities is more difficult.

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