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(202) 638 6988
601 Pennsylvania Ave., Ste. 900 South Washington, DC 20004

Is An S Corporation Right For My Business?January 2, 2014

When starting a business one of the most important decisions is to select the proper business entity for your business.  When creating your business, you have four basic entity types you can choose to use. Each one has its advantages and disadvantages, based on what you sell, your business’s finances, and the number of owners the business will have.

When choosing a business entity, you should consider: (1) the degree to which your personal assets are at risk from liabilities arising from your business; (2) how to best pursue tax advantages and avoid multiple layers of taxation; (3) the ability to attract potential investors; (4) the ability to offer ownership interests to key employees; and (5) the costs of operating and maintaining the business entity. However, when selecting a business entity, many entrepreneurs often do not consider an S Corporation because they do not understand what it is. This article explains what an S Corporation is and what its advantages and disadvantages are.

Types of Business Entities

The four most popular business entities are:

  1. Sole Proprietorship — An unincorporated business owned and run by one individual with no distinction between the business and you, the owner. You are entitled to all profits and are responsible for all your business’s debts, losses and liabilities.
  2. Partnership – A partnership is a business where two or more people share ownership of the business. Partners within a partnership contribute to all aspects of the business including money and running of the business. Partners also share in the profit or loss in the business. In addition, limited liability partnerships limit the liability of certain (passive) partners.
  3. Limited Liability Company — A limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. The “owners” of an LLC are referred to as “members.” Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations or other LLCs.
  4. S Corporation – An S corporation is a small corporation whose owners have elected to be treated as a partnership for tax purposes by the IRS under “Subchapter S.” S Corps are considered unique and separate entities thus limiting the liability of those that own it.

S Corporation Limitations

There are quite a few restrictions on the number and type of owners and classes of stock permissible in the S Corp. Limitations on S Corps include the following:

  • There can be no more 100 shareholders;
  • Shareholders must be individuals, estates, tax exempt organizations, or certain trusts;
  • There can be no nonresident alien shareholders;
  • There can only be one class of stock (although voting and nonvoting classes are permitted);
  • Banks, thrifts, insurance companies, possessions corporations and domestic international sales corporations cannot be S Corps;
  • S Corps must have a permissible tax year (generally with a December 31 year-end).

Limited Liability Company vs. S Corp

Both the S Corp and the LLC provide limited liability. The name“limited liability company” is misleading as all corporations offer limited liability. Both the S Corp and the LLC are untaxed business entities, which allows the business owner to avoid double taxation. Gains and losses “flow through” to the owners, and there is no federal or income tax owed by the business entity. An S Corp shareholder’s personal assets, such as personal bank accounts, cannot be seized to satisfy business liabilities. If an S Corp is started by two people, the implications of being a 50 percent shareholder in an S Corp vary from state to state, because no federal laws regulate shareholder rights and duties.

Rights of a 50 Percent Owner of an S Corporation

Many S Corps are formed by two partners each having a 50 percent ownership stake in the corporation. Being a 50 percent owner of an S Corp has advantages and disadvantages that should be considered before making the decision to form this type of entity with a partner. A 50 percent interest in an S Corp is technically a minority ownership interest. As a 50 percent owner, you have control over corporate decisions, or can block a vote against the other owners. You also have the ability to dissolve the corporation. The company’s status as an S corporation protects your personal assets from corporate liability, just as for a C-Corp (an organization formed with state government approval to act as an artificial person to carry out business). This provides you with more legal protection than operating as a sole proprietor, while benefiting from more advantageous tax treatment than a sole proprietor.

Corporate Deadlock

If the corporation has two 50 percent shareholders and the shareholders do not get along or are involved in various conflicts over how to run the business, the company is likely to experience corporate deadlock. The term corporate deadlock is used in corporate law to denote the blocking of corporate action by one or more factions of shareholders or directors when they disagree with some aspect of corporate policy.

A 50 percent shareholder only has some level of control over the business, and if one of the shareholders is also the company CEO, they would hold more prerogatives of control than the non-managing shareholder. In these cases the shareholders either do nothing, they litigate their differences or one shareholder may purchase the other shareholder’s interest. However, in the last case, it is usually difficult for two shareholders who do not get along to agree on the fair market value of the seller’s interest.

 

Ryan A. Hintzen

Attorney

The Hintzen Law Firm, PLLC

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