Let's break it down right from the beginning...an "S Corporation" is not a separate entity and it is not a type of company that you incorporate - as opposed to choosing to incorporate a C corporation. Now that we've said that, what is it?
The short answer is that an "S Corporation" is a corporate entity, organized under the laws of whatever particular state you chose to create it in, and which has elected to be taxed under subchapter S of the applicable IRS tax code. In other words, it's a choice that a company makes after it has incorporated. By default, every corporation that is created is assumed to be, and taxed as, a C corporation....unless the company chooses within a certain time frame after incorporating to send in a form and elect S subchapter tax treatment. So what is S tax treatment?
When we talk about taxing corporations, we're looking at basically two types of tax - single or double. Yes, I know it can get more complex than that in certain situations (for you tax gurus out there) but we're trying to keep it simple today. Every C corporation is subject to what people refer to as "double taxation". This means that when the corporation earns revenue, it is taxed at the appropriate and applicable corporate tax rate that particular tax year. Then, when that corporation pays its shareholders and employees (i.e. you the owner), those individual humans must then pay regular income tax on that income they were paid at that individual's applicable tax rate and/or the tax on the dividend paid to the shareholders. Hence, two sets of taxes.
When a company elects S treatment under the tax code, the IRS allows that company and the stockholders in that company to use what's called "pass through taxation", which basically means you put your share of the corporations profits and losses on your personal income tax return and pay taxes based upon that. Therefore, one tax.
At this point you've already decided you're a fool for not faxing over whatever piece of paper is going to give you this magical tax treatment and are rushing to download the form from the IRS website right now. Hold on a minute and keep reading if you are a company that calls itself a startup.
S subchapter designation is not available to every company or in every situation. The general purpose of it is to allow small businesses to not get hammered with taxes, thereby encouraging more people to be willing to open and run businesses, and stimulate the economy, yada yada. For this reason, there are certain restrictions placed on businesses that want to get and maintain S designation. I won't go through the whole list, but I will list the ones that matter for startups.
- S Corps can only have ONE class of stock. This means that it's impossible to do a Series A round or a Series Seed round, which are priced rounds that come with the normal and accepted requirement that the investor gets its own class of preferred stock with better terms than the regular investors and shareholders received before it. Deal breaker number 1.
- S Corps can only have 100 shareholders. If you somehow manage to organically grow your business and bootstrap it all the way to an IPO without VC money (i.e. having to give out preferred stock), you will never be able to go public as an S corp because you will need to be able to sell shares to potentially millions of individuals. 100 shareholders as a restriction ain't gonna get it, chief.
- S Corp shareholders can only be actual people. Human beings. That means that you'll never be able to accept VC money because VC's are all organized as either LLCs or Limited Partnerships. The same goes for many Angel groups that are sets of angel investors who have come together to form a mini conglomerate to pool and invest their money.
So, I can't say for you if you should or should not choose S class status after incorporating. I can only tell you two last things - most startups don't do it because they plan on, and usually do, take on investors within the first year; and choosing S class status and then reverting back to C corp status within a tax year could potentially cause you to have a HUGE tax bill because of how the IRS back dates corporate status a certain amount. Most startups simply avoid S class status because it will be literally impossible to maintain past year one (if they even make it that far) and any savings they might have had during their first year of minimal revenue could be erased by a later change in tax structure when they do have greater revenue and much to lose.
