Going S-corp? Stop and Think for a Moment!

If you’re organizing your business as a corporation, you have the option of electing taxation under Subchapter S of Chapter 1 of the Internal Revenue Code. Subchapter S allows for what is known as “pass-through” taxation — the profits and losses of the business are “passed through” to its owners (members or shareholders), who are then responsible for paying the tax on the business’ profits (or losses) in proportion to their share of ownership (or however tax liabilities are otherwise allocated). This is contrast to Subchapter C, known as “double taxation”, where the corporation is responsible for paying the taxes on its profits and losses — owners pay a second tax on the share of profits actually distributed to them (hence the double taxation).

(Note: your state may have different regulations for taxing corporations, although most tend to follow the federal scheme described above)

When a corporation is formed, it is by default taxed under Subchapter C. However, at any time it may elect to be taxed under Subchapter S by filing a simple form with the IRS (a corporation is technically required to file their election by the 15th day of the third month of the first tax year they intend to use the election, although the IRS usually shows great leniency in accepting late elections pursuant to directives from Congress). But before filing that form, it is critical to remember that once Subchapter S taxation is elected, it is not possible to revoke the election within five years after making the election without IRS consent.

If you’re forming a corporation for your startup with an eye to seeking investment, you might want to avoid a Subchapter S election — angels and venture capital firms may not look favorably on a company that is taxed under Subchapter S (since they would be taking on a tax liability with investment), and being able to revoke a Subchapter S election within five years of making it is by no means guaranteed.