Advantages and Disadvantages of S Corporation: Everything You Need to Know
Structuring your business properly is the first step to starting a successful business. 3 min read updated on February 01, 2023
Knowing the advantages and disadvantages of S corporation entities is important when you are structuring your business. Structuring your business properly is the first step to starting a successful business.
What is an S Corporation?
There are three popular choices when owners choose to incorporate a business — limited liability company, C corporation, and S corporation. For tax reasons with the IRS, an S corporation is a pass-through tax entity. Choosing to become an S corporation starts by choosing an election through IRS Form 2553. The S comes from the tax code that governs S corporations.
To create an S corporation you must:
- File Articles of Incorporation, typically with the Secretary of State in the state where you operate your business.
- Make the election using Form 2553 with the IRS.
An S corporation is run like a traditional C corporation and even issues stock. The shareholders have the same liabilities and protection as the shareholders of their C corporation counterparts. Unlike C corporations, S-Corps have the benefit of pass-through taxation, like partnerships and LLCs. With pass-through income, which is a huge write-off for S corporations, each employee is responsible for paying taxes on all income passed to them.
C corporations with less than $50,000 in annual taxable income are only taxed at 15 percent. This is a significantly lower tax rate than the rate the IRS charges when you make a $50,000 annual salary. It is important to know that some companies receive a sizable benefit for electing S corporation status while others do not.
Service businesses benefit from S corporation taxation by avoiding being classified as Personal Service Corporations (PSC) with the IRS. The IRS classifies a corporation that engages in services, like consulting, to the public as a PSC.
If you structure your business as an S corporation, you actually pay more than the 15 percent a corporation pays on the same amount of money. On the other hand, if you structure your business as an S corporation, you likely pay less than the 35 percent you pay on PSC earnings as a C corporation that offers the exact same services.
It is important to know the differences between S corporation structuring and C corporation structuring. For many businesses, the benefit is great enough to make them choose S status over C status when starting a business. However, you need to work with a reliable and trustworthy tax specializing legal advisor and a CPA to structure your business in the most beneficial way.
When you are transferring ownership, choosing S corporation status is particularly beneficial. Typically, the advantages of ownership transfers are only available to S corporations, not sole proprietorships and general partnerships. The S corporation is good for smaller businesses who would otherwise receive taxes under the C corporation tax laws.
S corporation status is good if the business:
- Provides services
- Has low start-up costs
- Does not need to make large purchases of business equipment
- Does not have to pay a large sum of money before it begins operating
- Makes a sizable income without a lot of effort and start-up cost
There are many other times an S corporation has advantages, too. Some of them are below:
- The business wants to receive pass-through taxation.
- Investors like to work with corporations, they respect S corporation status.
- You want to protect your personal property or assets.
- S corporation offers greater privacy.
S Corporation Disadvantages:
There are disadvantages to the S corporation structure as well — some of which are more influential than others. The most compelling disadvantages are below:
- There are fees associated with incorporating.
- S corporations pay additional fees annually to the local authorities governing corporation in their state.
- If you do not follow Section 351 of the tax laws of the IRS, you risk your business being considered a sole proprietorship or partnership when you exchange or sell business stock.
- You have to retain a minimum of 80 percent control in the company to continue being recognized as an S corporation.
- You may pay higher fees to government agencies and state governments because of your corporation status.
- You need to hire a tax attorney or CPA to handle complicated S corporation accounting.
- You need to use a good accounting software that helps you stay in compliance.
If you need help with weighing the advantages and disadvantages of S corporations, 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.