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Subchapter S Election Alternative

We have been assuming since IL #2 that we lacked the option to organise the company as a Subchapter S corporation because any corporation with nonresident alien (i.e. overseas) stockholders is ineligible for Subchapter S. It turns out that because of the way we're bringing in the non-California people, there is a reasonably attractive alternative we should consider (I will studiously avoid using the word ``option'' here except when I mean ``qualified employee stock option''--hence all the ``alternatives'' herein).

First of all, what is a Subchapter S corporation? A normal corporation has assets and liabilities just like an individual. When the corporation makes money, the only way it can get it out to the owners is by paying dividends, which are taxed twice, or by paying salaries. More important in the case of start-up companies, if the corporation loses money, the losses simply reduce the net worth of the corporation; they cannot be used to reduce the stockholders' tax liability (but they can be carried forward and used to offset the corporation's future profits). (However, if the corporation goes totally belly-up, the stockholders can deduct the loss on the then-worthless stock.)

A Subchapter S corporation works very much like a partnership for tax purposes while retaining the limited liability and flexibility of a corporation. The net profit or loss from the corporation is simply divided among the shareholders based on percent ownership and declared on their tax returns on Schedule E as regular income. Since most corporations lose money in the start-up period (while you're doing the development, writing off the equipment you bought, and doing initial advertising), a Subchapter S corporation can pass these losses directly out to the people who, after all, put up the money that's being lost, so they can reduce their income taxes. If the company loses, say, $20000 in the first year and you own 5%, that means you can deduct $1000 from your income. If you're in the 35% marginal tax bracket, that means you keep about $350 rather than giving it to Uncle Sam. Good pay for filling out a form.

If the company starts to make money and you decide you don't want to be Subchapter S any more, you can change to a regular corporation. Once you've done that, you can't change back to Subchapter S for 5 years.

One catch in Subchapter S is that California law doesn't recognise it. That means that earnings are double taxed in California. But remember that the California top tax bracket is only (did I say only?) 11%, and besides it's better to save Federal taxes anyway, even if you don't save on California.

O.K., now that we all understand what Subchapter S is, how can we go with it even though we have overseas participants? The thing that makes it possible is that the overseas people are acquiring their stock through employee stock options, not through direct purchases. The law says that if you have a foreign stockholder, you're ineligible for Subchapter S, but there's nothing wrong with granting an option to somebody, as long as it isn't exercised. As soon the holder of that option sends his money and says, ``Send me the stock'', you're immediately bounced out of Subchapter S, but up to that time it's fine.

Now the plan so far has been that the non-California people would get 60 day options, which they would immediately exercise for their initial stock purchase. The alternative is to make the initial options for, say, 2 years, not exercisable until either 1 year has passed or the company has dropped Subchapter S. Mike Riddle, who's out of state but not overseas could still receive a 60 day option and exercise it immediately--his case is irrelevant to this discussion because it's only overseas shareholders which cause the Subchapter S problem.

Now what would this mean for the domestic shareholders and the overseas people? The domestic shareholders would be able to deduct the initial losses by the company from their taxes. As most of the participants have other jobs and are in reasonably high tax brackets, this would result in substantial reductions in their tax bills. The overseas participants would be able to defer their initial stock purchase in the company, keeping their money until the option exercise time began. This would mean that they would not have to come up with the money right away, and if the company collapsed, would not be out the amount of the initial stock purchase, as they could let the option expire unexercised. If the company becomes successful, the option guarantees them their share at the initial offering price, so they can buy in on the same basis as the domestic people.

Let's look at the disadvantages. The domestic shareholders would be the only people putting up money immediately, so the company would not have access to the working capital generated by sales of shares to overseas people. The overseas people, once they exercised their options, would not have the prior losses of the company to reduce the corporate taxes paid on the (we hope) current profits of the company.

I think that in terms of financial benefits and disadvantages that this alternative is reasonable. The domestic people get to take advantage of tax benefits which wouldn't otherwise be available. The foreign people lose some benefits, but are compensated by having a year's use of their money before having to make the initial stock purchase, plus eventually owning a piece of a company whose initial capitalisation was done by the domestic people.

On the other hand, I think that this may simply be so confusing and hard to analyse that maybe we'd just be better off paying the money to the feds and getting to work writing software rather than further complicating the structure of the company. I personally feel very ambivalent about this matter. I certainly don't want to do anything which would make either the domestic or the foreign people feel like either was taking advantage of the other, so if anybody at all is concerned about it from that aspect, I think we should just forget it.

If we want to do it, here are the basic constraints: we have 75 days from April 9 to elect Subchapter S, and to do so we have to file a form with signatures of all stockholders and their spouses. Maybe we should start circulating the form just in case, so we have it if we decide to go ahead. Next, we need to get letters from all the overseas people giving their assurance that they understand the arrangement and that they approve it. This is required because they are foregoing the loss carry forward which reduces their eventual payouts on the stock (even though they are presumably compensated by not having to put up the money right away).

It seems to me that this is something that requires absolutely unanimous consent by everybody involved, so if you don't like it, let me know (and why). If you don't understand it, I'd be glad to ``clarify'' it at greater length (although at the present rate, I don't know how many pages that might take).

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Editor: John Walker