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Investing in S Corporations

You might be interested in investing in an S corporation.

Shareholders in S corporations can generally only be individuals who are U.S. citizens or lawful permanent residents. Shareholders cannot be other business entities or organizations. When a venture capital firm invests in an S corporation, that companies loses their S corporation status and convert automatically to a C corporation.

​caution​ S corporations can only have one economic class of stock. Meaning, you will only be able to buy common stock; you won’t be able to buy preferred stock.

An S corporation can divvy up governance rights as long as the economic rights of all of the shares is the same (for example, an S corporation can have voting and non-voting stock, as long as the voting and non-voting stock have the same economic rights).

Tax Issues With S Corporations

​caution​If you invest in an S corporation, you will be taxed on your proportionate share of the entity’s income, even if the company does not distribute any cash to you with which to pay the tax. (In contrast, to repeat, C corporations pay tax at the corporate level and thereby shield you from any direct tax consequences.)

If you want to make sure that the company distributes cash to you so that you will be able to pay the tax on the entity’s income that you are taxed on, you will have to enter into an agreement with the company that expresses this, and it should be part of your term sheet. One positive aspect of investing in S corporations is that if the company has an operating loss, you will be allocated some portion of those losses to report on your individual tax return.

​caution​ However, be aware your losses may be limited by the passive activity loss rules.

​danger​Another thing to watch out for: If you invest in an S corporation that does business across a number of states, you might have to pay income tax, or, in the event of an operating loss, still file a tax return in those states even if you don’t live in or visit them.

Investing in LLCs

Sometimes founders form LLCs as an easy way to get started.

Limited liability companies (or LLCs) can be simpler to form than corporations. LLCs also have the benefit of being pass-through entities for tax reasons by default. Meaning, the losses flow through to the personal tax returns of the owners, unless an election to be taxed as a corporation is made.

​important​ The financial and tax consequences of your investment depend on how the LLC is taxed for federal income tax purposes. This is a legal and business due diligence point you will want to run down right away.

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