Advantages and Disadvantages of a S Corporation: Everything You Need to Know
There are many advantages and disadvantages of an S Corporation.3 min read
2. S Corporation Defined
3. Advantages vs. Disadvantages
Advantages and Disadvantages of an S Corporation
There are many advantages and disadvantages of an S Corporation. With that being said, you should be mindful of all functionalities of an S Corporation before choosing to incorporate as such. If you want to incorporate your business, you can choose to operate as either an S or C Corporation. While both businesses have similar requirements in terms of filing certain documents, there are benefits and drawbacks to each one. Furthermore, when choosing which one to operate, you’ll want to think about the size of your business, short-term goals, and future plans for your business.
S Corporation Defined
An S Corporation is referred to as a pass-through entity, as its profits and losses pass through the corporation onto the shareholders, who are then responsible for filing such profits and losses on their own personal tax returns.
If you want a structure that provides pass-through taxation and allows salary and dividend distribution, then an S Corporation might be the best choice for you.
Advantages vs. Disadvantages
Perhaps the biggest advantage to operating an S Corporation is the pass-through taxation, as such corporations do not pay federal taxes at the corporate level. Instead, the money flows to the shareholders who then must report it on their personal tax returns. This is also beneficial for the shareholders and owners since they can deduct the business losses from their personal income tax, thereby potentially reducing their own taxes.
Another large benefit to operating an S Corporation is the limited liability, as previously mentioned. While C Corporations also provide the same level of limited liability, other types of business structures do not, including sole proprietorships and partnerships.
Other advantages include:
• The ease of transferring ownership or discontinuing the company.
• S Corp shareholders can receive dividends and other distributions that are tax-free to the extent of their own investment in the company.
• Interest in an S Corp can be freely transferred without any tax implications.
While there are many advantages to operating an S Corp, there are also some disadvantages too. As with any corporation, whether it is an S Corp or C Corp, a business that wants to incorporate must file several documents with the Secretary of State in the respective state in which it intends to operate. Such documentation includes Articles of Incorporation, documentation identifying the registered agent, and other paperwork relating to the industry in which your business operates. There are additional ongoing fees, i.e. franchise tax and annual reporting fees.
Furthermore, when incorporating, the business must meet the requirements of Section 351 of the Internal Revenue Code to ensure that the business won’t be viewed as a sole proprietorship or partnership for tax purposes. The rule itself specifically states that the owners must control at least 80% of the corporation’s stock if they want to defer the gains of the business to the owners and shareholders. If the 80% rule is not met, then the business could have additional tax implications, and be taxed as a sole proprietorship or partnership.
• If you do not meet the tax qualification obligations
• If you sell more shares than allowed
• If you have greater than 100 shareholders
Regarding the rule of having only 100 shareholders, it is an important item of consideration. If you want to have more than 100 shareholders, then an S Corporation is not for you. Furthermore, an S Corp can only have one class of stock. Therefore, the business cannot offer different dividends or distribution rights to different classes of investors. This, in turn, offers less flexibility in terms of allocating income and loss.
If you need help with learning more about the advantages and disadvantages of an S Corporation, or if you need assistance incorporating as an S Corporation, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5-percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law, and average 14 years of legal experience, including work with, or on behalf of companies like Google, Menlo Ventures, and Airbnb.