I lost huge money early in my career in not electing to switch my company from a Corporation to an S Corporation. I don’t want you to make the same mistake. Each year, the owners of C Corporations have an opportunity to switch their tax status with the IRS from C Corporation to S Corporation if they send in a simple election form by March 15. The goal of this post is just to get you thinking. Please triple-check everything and your individual circumstance with your tax advisers. As most of you know, a limited liability company (LLC) also has the advantage of being a flow-through entity for tax purposes. This post is primarily for C Corporation owners.
What is an S Corporation?
First, an S Corporation can only be owned by individuals (and I do not think foreign individuals). And second, there can only be one class of stock. So, no one can have Preferred Stock with preferences (liquidation, dividend, etc.) over the Common Stock. If you are an S corporation, the company does not pay income tax. Thus, you may avoid the double-tax conundrum when you try and distribute cash out of a C Corporation. This is caused because the C corporation pays income tax, and then the cash dividends (or gains on asset sales) are also taxed at the individual level. It’s pretty simple: C corporations pay two-levels of tax and S corporations only pay tax at the individual level.
How it works
It is a simple filing with the IRS. You tax ID # doesn’t change. Your name or incorporation doesn’t change. It is just a change in tax status. For the filing to be effective on Jan 1, it must be filed before March 15. Once you file, you pay no more income taxes at the company level. All the income flows to the owners and they pay income tax at the personal level. So, you no longer pay two levels of tax!
Benefits when you sell
Also, if/when you sell, you get huge benefits. Most buyers want to buy assets. If you sell them assets rather than stock, you pay cap gains tax at two levels (company and individual) and that is very depressing. It takes much of the value of your company and gives it to the government. If you elect to be an S corp, you declare the value of your company at the time of the S election. If you sell your business within 10 years of the S election (my tax advisers say sometimes only up to 7 years), you only pay double tax on the amount up to the declared value at the time of the election and everything above that is only taxed at the individual level. If you sell after 10 years, there is no corporate level tax on the sale at all. There is no downside to the S election and potentially millions of dollars of tax savings for you down the road.
Scenarios of taking investment after S election
1) Make S Election, no sale or investors. You are in good shape and there are no issues. Manage your company and celebrate only paying one level of tax.
2) Make S Election, and later Investor Requires C Corporation. Most all institutional private equity firms can only invest in C Corporations because they get their capital from many non-profit entities (university endowments, pension funds, etc.) that cannot have flow-through income that would endanger their non-profit status with the IRS. In this case, I think it’s a pretty easy change back to a C Corporation that can be done at any time of the year (probably should double-check this to make sure). Becoming an S Corp can only be done at the beginning of the year. It may be a little awkward to make the S Election and then go back to a C Corp later in the same year, but there are no IRS/legal issues that I know about. Presumably, if you were getting an investment from a private equity firm, the deal would be worth it for you to switch back. Having the S Corp in place right before the deal gets done probably also gives the private equity firm more flexibility on how they could structure the deal. For example, they could buy assets (better for them) from your S Corp (great for you b/c any value above the value you declared at the election won’t be double-taxed) and they might even want to create a new C corp to avoid liabilities in the old corporation. With my PE hat on, I can see how they would rather you be an S Corp even if they make the new entity a C Corp post-investment. For the record, Greybull Stewardship can invest in flow-through entities and greatly prefer to do so!
3) Make S Election, and later Investor Cannot Invest in S Corps (only individuals can invest in S Corps). In this scenario, you would create a new LLC as a wholly owned subsidiary of your S Corp and contribute all the assets of your S Corp to the new LLC. Then, the new investor buys equity in the LLC from the S Corp. The hassle here might be changing some of your regulatory approvals from the S Corp to the LLC and then creating new bank accounts and Tax ID #’s for the new LLC. I would also suggest that you keep the S Corp in place because you’ll be able to run some business expenses through the S Corp to save taxes that you might not want to run through the LLC because you have co-owners in the LLC. With Greybull Stewardship, this is the scenario that we have executed several times. It works well.
4) Make S Election, and later receive investment from an individual. No issues. The individual would be a co-owner of the S Corp with you. Only small item here might be that you can only have one type of stock here, so you can’t have a Preferred Stock and a Common Stock where different owners have different preferences. If your individual investor wanted that, you could execute scenario #3.
In my opinion, I think the S election helps you in all the scenarios. If you are a C Corp with individual owners, I beg you to make the S election now and you can share some of your tax savings with me down the road!