The Internal Revenue Service (IRS) defines an S corporation as one that elects to pass corporate income, losses, credits, and deductions through to their shareholders for federal taxation purposes. Shareholders in these companies report the flow-through of income and losses on their personal returns, being assessed tax at their individual income rates. This structure allows the company to avoid double taxation on corporate income.
An S corporation is responsible for taxes on certain built-in gains and passive income earned at the entity level.
Companies must meet specific requirements to qualify for S corporation status and continue to fit into that structure to continue receiving its advantages.
- It must be a domestic corporation.
- The company cannot have corporations, partnerships, or non-resident aliens as shareholders.
- There cannot be more than 100 shareholders associated with the company.
- It can only have one class of stock.
- The organization cannot be an insurance company, domestic international sales organization, or certain financial institutions.
Any companies that meet these stipulations should strongly consider the advantages and disadvantages of being an S corporation.
List of the Advantages of an S Corporation
1. It provides the limited liability benefits of corporate status.
If you own an S corporation or are one of its shareholders, then your personal assets are generally protected if the company goes out of business. Any creditors to the company must pursue only business assets unless a judge rules that inadequate bookkeeping allows them to pierce the corporate veil. That means you won’t need to worry about someone going after your car, house, real estate, or other tangible property if something happens to the business.
This advantage also applies to judgments that might get issued with regard to the business from litigation. S corporations have a distinctive, court-recognized existence.
2. You don’t need to meet state residency requirements.
An S corporation doesn’t require all of its shareholders to live in the state in which the business operates. It provides an unlimited potential for management hires, allowing the owners to provide funding outside of the scope of its daily operations. Different rules apply to LLCs, partnerships, and sole proprietors that don’t allow for this advantage unless a registered agent gets associated with the company.
3. It provides flexibility for owner-employees who use the company for income.
The structure of an S corporation works well for shareholders who also work for the company. It gives them the option to take a smaller salary for the work they provide and pay income taxes with regular payroll deductions. Then they can take the remainder of profit as distribution through their ownership share, which is a figure that is subjected to income tax rates only. If you suspect that your idea could take off and become quite profitable, this advantage can limit some of the financial liabilities you might face in the future.
4. You receive more privacy protection with an S corporation.
Nevada and Wyoming excel with this advantage, but it is also one that applies in most areas. When you file the articles of incorporation with your preferred state, then there are fewer information sharing requirements to consider. Your name and address aren’t necessarily automatically part of the public record, nor is the amount of money that you earn from the company each year with the reporting requirements.
That’s another advantage of the flow-through taxation rule. When the profits get distributed to the shareholders, then the tax occurs at the personal level.
5. An S corporation can write off its start-up losses.
The first years of a business usually involve having more expenses than losses. When you form an S corporation, then you can offset these costs against your personal income as a shareholder. If you were under a “regular” corporate structure, then those losses would get locked within the organization instead of getting applied to your income. That means you can still draw a salary from the company, take the loss on your personal return, and potentially end up owing no taxes as a result.
6. Some S corporations can use the cash method of accounting.
If your business doesn’t have any inventory, then it can use the cash method of accounting when it becomes an S corporation. That method is much easier to use than the accrual method, especially if you’re trying to do your books internally. You’ll still want to check with your accountant to see which option makes the most sense for your agency, but this advantage opens up a choice for some that isn’t available in other structures.
Corporations that don’t have this status in the United States must use the accrual method of accounting unless their gross receipts are $5 million or less annually.
7. It provides a straightforward transfer of ownership.
If a business operates as a sole proprietorship, then the company stops functioning if the owner passes away or can no longer function in their role. The same problem exists for LLCs and most partnerships. An S corporation is a little different. The interests in this organization can get freely transferred without starting any adverse tax consequences or impacting the existence of the company.
That means the S corporation can exist perpetually as the shareholders pass their interests down to the next generation or sell them to interested parties. As long as the current regulations continued to get followed, the company stays as an independent entity.
8. The S corporation status provides more credibility for the organization.
When a business decides to start operations as an S corporation, then this structure can help them to establish more credibility with their potential customers. Some employees, partners, and vendors may be more inclined to get involved with this venture because the effort to incorporate creates a formal commitment to the idea. This advantage may not lead to an increase in funding from VCs or angels, but it can help revenues to start growing faster.
List of the Disadvantages of an S Corporation
1. It sets the maximum number of shareholders at 100.
The S corporation structure requires that the company have a maximum number of shareholders set at 100. If more than that are desired for the organization, then it must transition into being a C corporation instead. Unless there are special circumstances that apply, all of the shares must be held directly by the owner in question. If you’re trying to secure more financing as an agency, then this limit can restrict the amount of expertise that you can bring into the organization.
2. The shares are subject to seizure and sale.
The shares of an S corporation are considered a personal asset. The courts in the United States see this ownership stake in the same light as common or preferred stock. If you have financial troubles for some reason, then creditors could take you to court to take advantage of the value you have in the company. Your shares are subject to seizure and sale to take care of judgments or specific obligations. That’s why it is in each owner’s best interest to ensure that their personal books are in good order because a bankruptcy on their end could result in losing the benefits of ownership.
3. High-income employees who receive distributions pay more in taxes.
The flow-through taxes that come from an S corporation get paid at the personal rate. That means the household tax bracket for the AGI will dictate what the exact percentage is for each shareholder. Individuals who receive a significant salary from the company or have a spouse or partner that contributes to a higher income level will create a higher obligation to the government than someone without those income features.
This disadvantage is the primary reason why some CEOs choose to take a salary of only $1 from their company. It gets marketed as a positive to talk about their selfless nature, but it is really just a way to limit their tax liability at the end of the year since they’ll get paid through distributions instead.
4. The shares in an S corporation don’t generally appreciate in equity.
The value that you receive from owning shares of an S corporation is usually based on the amount of profits earned during the year. It doesn’t carry a changing equity value figure as you would see with common shares traded on the stock market. That means it produces income without appreciating in value over time. If the company isn’t profitable, then the value of your shares is going to be similar.
This disadvantage becomes problematic if the sale of assets creates a capital gain for the S corporation. It incurs higher taxation responsibilities than you would see with other pass-through structures, such as a limited partnership or a limited liability company.
5. You can lose the S corporation status because of a violation.
If an organization has a non-resident stockholder or shares placed in the name of a corporate entity, then the IRS reserves the right to revoke the status of the organization. It must then transition to a C corporation or an LLC unless a partnership or sole proprietorship is possible. Then the government will charge the organization back taxes for three years and impose a 5-year waiting period before the agency can re-apply for its S corporation status back again.
It is up to the company to ensure its due diligence is complete before pursuing this status. The articles of incorporation should cover what the organization can do if a resident alien changes their status to reduce its risk in this area.
6. S corporations can only issue one class of stock.
Public companies can issue multiple stock classes for preferred and common shareholders. Multiple series are an easy way to raise money to expand operations or fuel research and development projects. S corporations don’t have this luxury. The government restricts them to the issuance of one class of stock only, which means the opportunities to do some fundraising are somewhat minimal.
You’ll still receive the asset protections made available by the corporate status, but it does not give the organization a way to offer incentives to particular investors. This disadvantage also means that the company has less control over the business and limitations on the overall value.
7. A 2% ownership stipulation applies to S corporation shareholders.
Any employees or owners that hold at least 2% of the company’s shares cannot receive any tax-free benefits from their activities. That becomes problematic for any company with 50 or fewer shareholders as that percentage becomes almost automatic. That’s why this structure tends to be less attractive to outside investors since the pass-through setup and shareholder limitations create growth restrictions.
8. All S corporations must hold required meetings to fulfill their obligations.
The status as an S corporation comes with the same requirements to have regular meetings as an LLC, C corporation, and some partnership structures. That means you must maintain your company minutes and have them available for inspection upon request in some areas. That means you must factor in the cost of operations when you start looking at the pros and cons of forming this kind of business.
If you’re a small business owner or you’re the only planned shareholder, then an LLC might be the better option to choose.
9. Everyone in an S corporation must earn a “reasonable” salary.
All officers and owners that work in an S corporation must earn a salary that is similar to what their skills and position would earn on the open market. This stipulation from the IRS can put a lot of pressure on a startup company since labor is often the largest expense on the budget line. There are no exceptions that apply, even if the business isn’t profitable. This disadvantage is one of the primary reasons why companies wait to file for this status, even if they qualify for it immediately.
10. You don’t receive the option to operate on a fiscal year.
Unless you can establish a business purpose for operating on a fiscal year, then an S corporation must adopt the calendar year for tax purposes in the United States. Companies that have seasonal business cycles that end in the spring or summer typically receive this exemption. If you are in the retail sector, then the calendar year is probably the best option to pursue anyway.
You will want to review IRS Publication 538 – Accounting Periods and Methods to ensure that your S corporation is in compliance with expectations. If you’re already using the calendar year, then it is probably easier to stick with that structure.
11. The IRS has the authority to recharacterize dividends.
Because an S corporation can distribute salaries and dividends to shareholders, the IRS typically pays closer attention to the financial records of these organizations. The payments receive scrutiny to ensure that there aren’t efforts being made to avoid tax responsibilities. One of the disadvantages that everyone must accept with this business structure is the authority of the government to recharacterized dividends as wages.
That means the corporation receives more exposure to employment tax liability and withholding responsibilities. It will cost the organization a deduction for compensation paid, and that can impact the bottom line in several adverse ways.
If you have weighed these S corporation advantages and disadvantages and feel like it’s the right structure to use, then the IRS requires you to submit Form 2553 Election by a Small Business Corporation. This document must be signed by every shareholder before the government will consider the status.
Once a company becomes an S corporation, then it may be liable for income tax, estimated tax, excise taxes, and employment taxes like FUTA, Medicare, and Social Security. Each requirement has a different form you must file to ensure that you stay in compliance with the current regulations.
Employees may be responsible for income tax and making quarterly estimated tax payments.
This guide is intended for informational purposes only. It should not serve as a substitute for professional advice if you are thinking about the formation of an S corporation.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.