Clark and Lois moved to Wichita, the Air Capital of the World, to work among other leaders in aerospace and for Clark to be closer to his stepparents. Lois has two patents on a holographic simulator at the forefront of interactive, virtual reality technology. Clark owns a patent on a tactile sensor technology that provides a sense of touch when interacting with switches and controls in a holographic image. They also are adapting this system for use in overriding failed switches or components in cockpits during flight and are working with a major manufacturer to introduce this safety technology on its next generation of jets. What form of business makes sense for this super duo?

Clark, “Lois and I would like to formally combine our ideas in a company, and we want our personal assets shielded from what happens in the business.”

Lois, “I have some money from a golden parachute to invest in our company, but, of course, we don’t expect to make money for a while. We expect to operate at a loss for at least a year.  We aren’t quite ready to seek venture capital, but will need to do so.”

Clark, “And, at some point, Lois and I would like to go public.”

At first, it appears that an S corporation is the form of business that will best serve Clark and Lois.  Here’s why.

An S corporation is an excellent shield against personal liability. It also is well-suited for any business that will be seeking outside capital, if such funding is not imminent and the founders, like Clark and Lois, would personally like to take advantage of the early anticipated losses of the business.

A corporation provides a “corporate veil” or shield against personal liability for activities conducted by the corporation. So long as all corporate formalities have been complied with, the shareholders of the corporation, Clark and Lois, will only be liable for the debts, obligations and liabilities of the corporation up to the amount of their respective investments.

There are two primary types of corporations: an S corporation and a C corporation. They are called S corporations and C corporations because they are bound by the rules and regulations of Subchapter S or Subchapter C of the Internal Revenue Code. An S corporation refers to an eligible business that is formed as a corporation under state law and elects to be taxed at the ownership level like a partnership.

One of the differences between a C corporation and other structures, such as an S corporation, is in the way they are taxed. Unlike an S corporation that does not tax the business directly, C corporations are required to pay both federal and state taxes at the entity level. While other structures like the S corporation only mandate that shareholders or interest holders pay taxes on any profits they receive, C corporations face the possibility of being double-taxed since both the business and the owners must pay taxes on profits.

An eligible business can elect to become an S corporation by submitting Form 2553 “Election by a Small Business Corporation” to the IRS. Since an S corporation is a “pass through” entity, i.e., profits and losses of the corporation pass through to the individual shareholders, Clark and Lois can each account for their pro rata share of income, deduction, loss and credit. The S corporation structure will allow Clark and Lois to write off their early losses.

Another advantage of an S corporation is that it can establish a salary or bonus for its stockholder-employees, and they would only pay Social Security and Medicare taxes on such salary or bonus.  The caveat is that the salary or bonus must be reasonable and not too low for the job performed. If the salary or bonus is too low, the “dividends” may be treated as salary or bonus and the IRS may assess penalties on the underpayment of taxes.

An additional perk of an S corporation is that non-wage income earned in such a “pass through” business is not currently subject to income tax at the state level in Kansas. More money for Clark and Lois.

Lois, “What form of corporation is best to attract venture capital, and eventually go public?”

A C corporation is well-suited to attract venture capital, especially if the exit strategy is an initial public offering or IPO. It is wise to perform due diligence on prospective funds.  Get to know their key personnel and expectations and requirements up front.  From a tax perspective, certain venture capital funds avoid investing in “pass through” entities such as S corporations because the pass-through mechanism may require the fund to report losses to the fund’s investors, or may require the fund’s foreign investors to file U.S. tax returns. Under an S corporation, all shareholders must be U.S. citizens like Lois, or residents, like Clark. In addition, an S corporation cannot have more than 100 shareholders and can only have one class of stock. These features are not attractive to raising capital, especially if a venture capital fund would want preferred stock in return for their investment.  On the other hand, some angel investors or family offices may prefer to invest in “pass through” entities for the reasons set forth in the prior paragraphs.

When venture capital funding is imminent, Clark and Lois can convert the S corporation to a C corporation by terminating the S election, with tax ramifications of course. Unlike an S corporation, a C corporation may have an unlimited number of shareholders and different classes of stock. The flexibility to issue different classes of stock facilitates raising capital by making a broad range of financial instruments accessible, including preferred stock, warrants, convertible notes and subordinated debt.

Robert J. Vincze
robert@depewgillen.com

March 2017
Depew Gillen Rathbun & McInteer, LC

 

This article is based on hypothetical facts and is issued for general informational purposes only.  It is not intended to be construed or used as legal advice.