What is an S corporation?
An S corporation is a U.S. tax classification under Subchapter S of the Internal Revenue Code that allows a domestic corporation to pass corporate income, losses, deductions and credits through to its shareholders for federal tax purposes: avoiding the double taxation that applies to C corporations. The entity itself remains a corporation under state law; the “S” designation is purely a federal tax election filed via IRS Form 2553.
Key requirements
- Domestic corporation: must be incorporated in the U.S.
- Shareholder limits: maximum 100 shareholders.
- Shareholder eligibility: only U.S. individuals, certain trusts and estates; no corporate, partnership or non-resident alien shareholders.
- Single class of stock: only one class of common stock with identical economic rights: disqualifies most venture-style preferred stock structures.
S corp vs. C corp vs. LLC
- S corp: pass-through tax, restricted ownership, no VC funding possible.
- C corp: double tax (entity + shareholder dividends), unlimited shareholders, default for VC-backed startups.
- LLC: pass-through tax, flexible ownership, but generally less VC-friendly than C corp.
Why VC-backed startups rarely use S corps
The single-class-of-stock rule and 100-shareholder cap make S corps incompatible with the preferred-stock financing structure venture investors require. Founders sometimes start as S corp for tax simplicity and convert to C corp before raising priced rounds: typically painful and expensive.
Do: consult U.S. tax counsel before electing S corp status if VC financing is on the horizon; convert early if so.
Don’t: assume the pass-through tax benefit always wins: the structural constraints often outweigh the savings for growth-stage companies.
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