The following post is from famed Slicing Pie-friendly lawyer Matt Rossetti, but does not constitute legal advice nor does it necessarily reflect the opinion of other Slicing Pie lawyers. It is however, interesting enough to be included in this Slicing Pie blog!
A common question that I receive from founders is “Can I make the S-Corporation election for my startup if I am using the Slicing Pie model?” The purpose of Slicing Pie and any form of dynamic equity is to fairly and proportionately distribute equity amongst cofounders of a new venture. The Slicing Pie model provides founders with an equity allocation framework and a recovery framework for when parties decide to leave the startup for any number of reasons. Slicing Pie works well for limited liability companies, partnerships, and C Corporations. However, it is not appropriate for ventures that are taxed as S Corporations.
What is an S-Corporation?
According to the Internal Revenue Service, an S Corporation is a company (generally an LLC or a C Corporation) that elects to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S Corporations report flow-through income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S Corporations to avoid double taxation on income at the entity level. However, S Corporations are responsible for tax on certain built-in gains and passive income at the entity level.
- To qualify for S corporation status, a company must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).
How does my company become an S Corporation?
In addition to meeting the criteria above and having properly drafted governing legal documents, a company becomes an S Corporation by submitting Form 2553 to the IRS in a timely fashion. To complete Form 2553, the founders must know who the company’s shareholders or members are and exactly how many shares or what percentage of the company that each shareholder or member owns.
Why doesn’t Slicing Pie work for S Corporations?
First and foremost, the Slicing Pie model is, by definition, dynamic. This makes it impossible to properly complete and file Form 2553 with the IRS.
Second, Slicing Pie is appropriate for bootstrapped pre-revenue startups only. Under the Internal Revenue Code, S Corporations are required to pay each shareholder a “reasonable” salary. In order to pay said reasonable salary, the company generally must be profitable. Most accountants will recommend that startup founders make the S Corporation election if and only if their venture will have approximately $80,000.00 per year in top line revenue. Bootstrapped startups generally cannot afford this salary and, if the startup can afford to pay fair market salaries, there is no reason to use a dynamic equity model like Slicing Pie.
Third, many times Slicing Pie ventures have entity and non-resident alien owners. In other words, other companies and parties who are not US citizens or residents choose to work as participants in the Slicing Pie model in the hope of receiving a windfall in the future upon exit. Because S Corporations cannot have entity shareholders (partnerships and corporations), it would be a disadvantage for a Slicing Pie venture to make the S Corporation election. It should also be noted that international contractors (non-resident aliens) cannot be owners of S Corporations which could limit your venture’s access to talent in today’s economy.
All of these matters are easy to navigate with competent legal and tax counsel. If your venture has not retained counsel or your current counsel requires assistance, schedule a free consultation to discuss an engagement with Matt Rossetti now.