Build It So They Will Come

S Corporations: Better Taxation, Harder Fundraising

S corporations offer their owners limited liability protection and tax advantages. In most situations, business principals aren’t personally responsible for company debts or liabilities. And S corporations are pass-through entities—structures that tax company profits just once on disbursement to shareholders, rather than twice (first at the corporate level and again at the personal level). Losses are similarly passed through, a feature that often appeals to owners looking to offset gains from other investments.

Although they offer owners attractive taxation, other S corporation rules can make attracting outside investors difficult. Some trusts may invest in S corporations, but other entities—including most venture capital firms—are not eligible to own S corporation shares. “The restrictions on types of investors makes S corporations a less realistic option—it’s very limiting,” says Barbara Rummel, a partner at Minneapolis-based law firm Lindquist & Vennum.

Even if they could invest, many private equity firms wouldn’t like the stock they’d get. S corporations can issue only one type of stock, treating each shareholder equally. That’s a turnoff for many private equity firms, which usually expect to receive preferred stock. Preferred stock offers them liquidation preference, extra voting rights or dividends, the ability to elect a greater percentage of board members than other stockholders, or the right to ask the company to buy out their interest at a predetermined time or price.

So, an S corporation that needs money has to get it from individuals. That fundraising strategy might be sufficient, if the capital goals are small, says Mike Moore, director of the William C. Norris Institute at the University of St. Thomas’s College of Business in Minneapolis. “If you need half a million to a million dollars, you may be able to raise that money from friends, family, or angel investors,” he says.

However, it’s relatively simple to accidentally lose S corporation status, Rummel cautions. An S corporation may be inadvertently converted into a C corporation—if it sells stock to a corporate investor, for instance, or issues preferred stock. If a company accepts an ineligible investor or issues preferred stock without realizing the implications of that mistake, the move can spell the end of a deal with a buyer who wants the S corporation’s single-layer tax treatment. “I’ve seen a $50 million deal where there was enough concern about the company’s S corporation eligibility status that the deal didn’t happen,” Rummel says.

Some investors, particularly those with limited partners of their own, object to the paperwork hassles the S corporation’s pass-through profits generate. For instance, Split Rock Partners, a venture capital firm based in Eden Prairie, has multiple limited partners that are foundations with investments in the firm and other venture funds. If they receive pass-through income, they file additional tax forms. As the number of investments increases, the paperwork mounts. “You could potentially have 400 different income streams coming in that you have to account for, and they’re not related at all to your business,” says Michael Gorman, Split Rock’s managing director.

Limited partners also object to paying higher tax rates. They typically pay ordinary income tax rates on pass-through money. They’d pay the lower capital gains rates if the money stayed in the corporation (as it does with a C corporation) and came to them only after an investor buyout.