Legal Question in Securities Law in California

Electing as a S-Corp / What's considered ''shareholders''?

We're a startup, just did a simple registration as a C-corp. We estimate for the foreseeable near-term future (the first few years), we will be running at a loss. We also plan to have employee stock option plan to attract & retain talents.

We're considering whether to switch to a S-Corp now (know we have very limited time to make that election.)

Few questions:

1) For tax purpose, having a pass-through S-election to our existing shareholders (few and won't exceed the 100 limit) is quite attractive for the initial period.

However, if we later set up an overseas subsidiary company and offer stock-option plan - the fact that overseas employees are only stock option holders (not yet shareholders since the options won't get not exercised for quite sometime)

- does that prevent us from being eligible for a S-Corp?

2) To further clarify the #1 question, are option holders = shareholders? or only when the options being exercised?

3) Once elected as a S-Corp with IRS, do we need to do any sort of legal corporate paperwork to formalize for the S-corp? If so, is there any ''time limitation'' to execute that?

4) If there is a need to switch from S-Corp to C-Corp again, what's needed?

Thanks a lot!


Asked on 4/26/07, 12:05 pm

1 Answer from Attorneys
Bryan Whipple Bryan R. R. Whipple, Attorney at Law

Re: Electing as a S-Corp / What's considered ''shareholders''?

Your posting asks several very good questions, and I'd like to start out by recommending that you set up a working relationship with both a good business lawyer and a good accountant with tax knowledge to have available for face-to-face discussions of these and similar issues as they areise in the course of your business growth. The cost is small in relation to the potential costs of a mistake.

Having said that, I would mention:

1. Option agreements can be written that (a) don't create additional stockholders and (b) don't create a second class of security, either of which could imperil your "S" election; but you'll need expert advice in drafting it (which would be true even if you weren't an "S").

2. "S" corporations can't have nonresident aliens as shareholders.

3. Once the IRS acts on your Form 2553, all you need to do is refrain from anything that would disqualify the corporation.

4. Check your bylaws and shareholder agreements to make sure they are compatible with "S" status.

5. Make sure your Articles authorize sufficient shares to accommodate eventual full exercise of the options.

6. Make sure you report any stock issued to the Commissioner of Corporations on the right 25102 form.

7. Switching from an "S" back to a "C" is easy, and can happen by default. When the time comes, as determined by your accountant, have your lawyer or accountant prepare a notice to the IRS that you've elected to drop the "S" election.

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Answered on 4/26/07, 1:53 pm


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