The Misleading Attractiveness Of S Corp Elections

Republished By Plato

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RYAN NASH
, COO
, GUST LABS, INC.

22 Mar 2024

Investors prefer investing in Delaware C Corps which don’t allow founders to take personal tax losses for early expenses. Many founders are tempted to make an S-Corp election which allows a pass-through tax treatment similar to an LLC. While that could be a small short term gain in the early days, it can jeopardize a much larger tax free gain in the future ($10M+). Most typical startups should avoid tinkering with their tax treatment; if it really seems important it is best to tap in a professional.

The S-Corp Election Explained

The Internal Revenue Code (IRC) provides C-Corporations the option to elect pass-through status: they can simply file Form 2553, which changes the C-Corporation into a “Small Business Corporation,” popularly known as an S-Corporation.

To be eligible, a company can’t operate within certain industries, and must have fewer than 100 shareholders, all of whom are individuals (or “certain trusts” and estates) rather than corporations or partnerships, and all of whom are residents of the United States. In addition, an S-Corporation can only have one class of stock.

Building a startup is hard. Mission Control will help you chart your course.

This makes an S-Corp seem perfect for an initially founder-funded startup. Write off some early losses, then when your first investors arrive, you simply drop your S-Corporation election and turn into an investor-friendly C-Corp with the ability to issue the Preferred stock that they will insist on purchasing. Also, professional investors often make investments through a corporation or partnership—both of which are deal-breakers for S-Corp status.

As neatly as the Sub-chapter S election solves the taxation issue, it turns out that there are actually millions of reasons why a high-growth founder may well want to start out directly as a C-Corp and stay that way.

Why you would want to be a C-corp instead

C-Corps can eliminate taxes on up to ten million dollars or more of your personal gains. Under certain circumstances, stock issued by C-Corporations counts as Qualified Small Business Stock (QSBS)—and after five years of ownership, the gains made on the value of this stock can be written off the personal taxes of the stockholder up to $10,000,000 or 10x the stockholder’s adjusted basis in the stock, whichever is greater.

The kicker? S-Corp stock isn’t eligible for this benefit, and neither is any form of equity in an LLC. Additionally, the company needs to be a C-Corp for sufficiently all of the 5 year holding period. This is purely a perk for C-Corporations, and is why high-growth entrepreneurs—ones optimizing for an exit or an IPO—choose the C-Corp approach.

There may be a select few cases where an S-Corp election makes sense for your startup—say a capital intensive business with excessive early loses—but if you’re considering it know there is a lot of nuance and other significant ramifications to consider so it is best to work with professional legal counsel and accountants if you’re trying something non-standard. There is very little legal precedent for what counts as “sufficiently all” for that holding period so trying to be cute with timing is risky; talk to a lawyer before filing anything.

At the end of the day, this is the question that all startups considering LLC or S-Corp status have to answer: is the possibility of saving a small amount in taxes deducted from your personal income this year worth potentially paying taxes on up to ten million dollars in gains when you make it big?

How Mission Control Can Help

S-Corp questions frequently arise during our guidance sessions, particularly concerning founder stock and tax implications. Recently, in Mission Control, we hosted a specialized Q&A session featuring tax expert Bert Wilson from KMK Ventures. This exclusive deep dive session was designed to provide founders with clarity on various tax considerations and address any lingering questions or concerns. Unlike a typical webinar, this intimate session gave our audience the opportunity to engage directly and receive actionable insights.

You too can access Gust’s own dedicated startup support program, Mission Control. It’s tailored to cut through the noise and provide affordable access to experts that will answer all your questions on topics like like S-Corps and QSBS.

Building a startup is hard. Mission Control will help you chart your course.

This article is intended for informational purposes only, and doesn’t constitute tax, accounting, or legal advice. Everyone’s situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.