How An S Corporation Election May Affect Financing And Exit

Five Restrictions Founders Should Understand First

For unseasoned founders, making an S corporation election for their new company can sound almost too good to pass up. The business generally avoids entity-level federal income tax, and distributions to a shareholder-employee may avoid burdensome employment taxes that apply to wages. So why are so many venture-backed startups organized as C corporations? The answer is that the same S corporation rules that can produce tax savings for a closely held business can become significant constraints once a company begins raising capital, issuing equity to employees, or planning for an exit.

1. Company Ownership Restrictions

S corporations face strict shareholder eligibility rules. They generally may not have partnerships, corporations, or nonresident aliens as shareholders, although certain trusts, estates, and tax-exempt organizations can qualify. They are also generally limited to 100 shareholders. These restrictions may not matter when