It can be common (and certainly understandable) for both business owners and their accountants to primarily focus on minimizing taxes when deciding in what form to do business and whether or not to make an S corporation election with the IRS.  An important advantage to an S Corporation election can be the avoidance of double taxation of income (once when the corporation is taxed for this income and once when shareholders are taxed for the distribution of this income as dividends), while still retaining other benefits of incorporation.

However, when considering whether or not to make an S Corporation election to avoid the double taxation of income, business owners may also wish to consider the restrictions on debt and ownership of S Corporation shares imposed by the federal government, and the implications of these restrictions for raising the necessary financing for their business.

S corporations may not have more than one class of stock.  This limitation, for example, will preclude the creation of a second class of preferred stock which may limit the options for certain businesses to raise capital.  [Remember that preferred stock generally entitles the holder to a fixed dividend, the payment of which takes priority over any dividends paid to holders of common stock.]

S corporations generally may not have more than 100 shareholders, only certain types of qualifying trusts may hold S corporation stock, nonresident aliens may not be shareholders, and other corporations and partnerships may also not be shareholders.  These ownership restrictions may limit the ability of certain businesses to raise the necessary equity capital they need, either in the short- or long-term.

Finally, in enforcing the requirement that S corporations may only have one class of stock, the federal government places restrictions on the types of debt that may be incurred by an S corporation.  S corporations are only permitted to have what is referred to as “straight debt.”  Straight debt means a written, unconditional promise to pay a fixed amount of money on demand or on a specified date provided that: (a) the interest rate and/or payment dates are not dependent on business profits or the discretion of the borrower; (b) the debt cannot be converted to stock; and (c) the creditor is generally an individual, an estate, a qualifying trust, or a person who is actively and regularly engaged in loaning out money.  Again, these straight debt restrictions may limit the options of certain businesses to generate the financing they need.

Take the time to understand what form of doing business is right for your venture, including whether the benefits of any S corporation election outweigh the imposed restrictions.  Do you want to know more about estate planning considerations when deciding on an S corporation election with the IRS?  Consider the following two additional posts: (a) Contemplating S Corporation Status?  Consider Estate Planning Flexibility and Restrictions on Ownership; and (b) Contemplating S Corporation Status?  Consider Estate Planning Flexibility and Preferred Stock Limitations.

[Legal advice not only involves an understanding of the law, but the application of the law to a particular set of circumstances or facts.  Typically blog posts are imperfect tools to address the subtlety and exceptions of the law that may apply in particular situations.  As a result, the information in this blog post does not represent legal advice.  If you are in a situation where you need or desire legal advice, we would be happy to help.  Check out our Contact Us page, and feel free to set-up a no-charge initial consultation.]