Second-Class Investors and S Corporations
An S corporation is a kind of hybrid between a partnership and corporation. Small business owners typically choose one or the other of these structures for their enterprise, but at times they do so without fully understanding restrictive rules. As you are setting up your new business it is very important that you consult a Bryan business attorney to make sure you avoid any of the pitfalls that new business owners often experience. One of these is the question of having multiple levels of investors.
Multiple Classes of Investors
Most corporations have a number of different classes of stock. These reflect a difference in voting and other rights in the company. The first class of stocks are usually kept in the hands of major investors. Second class investors are brought in as a means of increasing revenue for the company, while at the same time sacrificing a reduced amount of ownership and control in the company. Small investors are drawn to such a purchase because they can and do earn profits with companies that are experiencing growth.
The Problem for S Corporations
As per the rules for setting up an S corporation established by the Treasury Department, there can only be one class of stock. In return shareholders enjoy what is termed “flow-through” taxation, which means that the corporation is not taxed initially. Instead, dividends are taxed solely. This is highly advantageous both to shareholders and to the corporation, for in a traditional C corporation a second tier of taxation is imposed. This, in turn, eats away at any profits that are realized by shareholders.
Unfortunately, if an S corporation is set up with a second class of investors, the company faces sanctions as well as loss of its S status. It is, therefore, vital that those who establish the business charter understand the boundaries within which they must operate. Treasury regulations establish that a corporation is considered to have one class of investors if voting, distribution, and liquidation rights are identical for all outstanding shares.
If You Have Questions about Second Class Investors
If you are considering establishing your company as an S corporation it is important that you understand the implications of doing so. Call a Bryan business attorney today to arrange a consultation at Peterson Law Group: 979-703-7014 or 936-337-4681.