Raising with an S-Election

An S-Corporation is not a special type of company. Rather, it’s a special tax designation that a company can make with the IRS. So, if you are an LLC or Corporation, you can make an S-Election and become an “S-Corp” (although the reasons for doing so as an LLC or Corporation may not be the same).

With an S-Election comes some benefits (like the ability to receive a W-2 and be considered an “employee”) but also some additional rules\regulations\or drawbacks (like the limit of 100 shareholders, the requirement that the shareholders be residents of the US [mostly], and that only one class of stock is allowed).

If you want to raise money from outside investors, an S-Election is going to pose a number of potential hurdles – some of the biggest ones being:

  1. One Class of Stock: This is big. Investors generally want “preferred” stock which grants them certain rights over common stock holders – like more votes, getting paid first, or whatever else you’re willing to do for their money. If your company has made an S-Election, granting the majority of “usual” preferred stock rights to investors will be nearly, if not totally, impossible. *There is some flexibility (but not much), and if anyone wants to talk nerdy about S-Corps, I’m happy to abide.*
  2. Limit of 100 Shareholders. This is less of a concern, but still an issue. S-Corps are great when the group of shareholders will be relatively small, but if your company plans to raise from a large group of investors (over 100), an S-Election is not possible.
  3. US Residency Requirement. Owners of an S-Corp must be US residents. That may not seem like a huge problem, but a ton of investment in US companies comes from abroad. Unless the investors are US permanent residents, or meet a residency requirement, they cannot invest in an S-Corp.

So, in general, I advise clients to think about the future of their company before making an S-Election; be prepared to ditch the election if major investment is on the horizon; and discuss your options with an accountant – because everyone’s situation will be different.

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