Understanding the disadvantages of an S Corporation can help you determine whether to elect S Corp status. An S Corporation is a business which is taxed as a “flow-through entity,” meaning that shareholders are only taxed as individuals instead of both individually and on the corporate level. As such, they avoid C Corporation double taxation.

What Is an S Corporation?

An S Corporation is treated as a pass-through entity for federal tax purposes. You can elect S Corp status through the Internal Revenue Service (IRS).

When a business is treated as an S Corp, it doesn't pay corporate taxes. Instead, any business losses or profits are “passed through” to the shareholders. These individuals then report those losses and profits on their personal tax returns.

You can create an S Corporation by filing an Articles of Incorporation with your Secretary of State's office. Once your business is an S Corporation, you can issue stock, protect yourself from personal liabilities, and govern the business with officers and directors. One of the most attractive reasons for creating an S Corp is the fact that your personal assets cannot be seized if the business owes money. There's also no double taxation at both the corporate and individual level, which differs from a regular corporation.

Who Can Qualify to Elect S Corporation Status?

Not every entity qualifies for S Corp status. The IRS has several restrictions in place, including:

  • The business may not have more than 100 shareholders
  • Those shareholders must be U.S. citizens or permanent residents

These qualifications mean that a partnership or limited liability company (LLC) cannot be a shareholder of an S Corporation. If your business meets these criteria, remember that there is a deadline to apply for S Corp status with the IRS. Those forming a new business have 75 days from their incorporation date to file Form 2553.

Advantages of an S Corporation

There are several advantages to forming an S Corporation. For starters, an S Corporation protects shareholder assets and isn't required to pay federal taxes at the corporate level. Business income or losses “pass through” the shareholders reporting it on their own tax returns, meaning that any losses can offset other shareholder income on tax returns. Effectively, S Corporations avoid the dreaded “double taxation” regular corporations must deal with as well as:

  • Shareholders can be salaried employees and receive dividends from the company
  • Easy conversion to C Corporation status
  • Interests are easily transferred without tax consequences
  • Are not subject to the accrual accounting method imposed on regular corporations
  • Credibility with employees, vendors, customers, and partners
  • No state residency requirements
  • Income-splitting potential
  • Court-recognized existence
  • Privacy protection

Disadvantages of an S Corporation

Despite the advantages associated with S Corporations, it's important to understand the drawbacks. For starters, you must incorporate the business by filing an Articles of Incorporation with your state, find a registered agent, and pay the fees. Any mistakes made regarding consent, election, stock ownership, and notification to the IRS can result in losing your S Corp status. Losing status is rare, but it's an issue worth considering.

S Corporations must adopt the calendar year as their tax year unless there's a good reason for having a fiscal year. S Corporations are also limited to one stock class, although they may have both voting and non-voting shares. Because of this fact, investors must be limited to a single class and they must be entitled to distribution or dividend rights. Remember, S Corporations may not have more than 100 shareholders at a time.

Other disadvantages associated with S Corporations include:

  • Restricted ownership (foreign ownership is prohibited)
  • Wages may be reclassified as dividends, which costs the company a deduction for paid compensation
  • Since S Corporations are restricted to one class of stock, income or losses are not easily allocated to certain shareholders; these are allocated by stock ownership
  • Fringe benefits are taxable as employee-shareholder compensation
  • Limited type of shareholders and the ownership interests they can have
  • Extra banking, regulatory, or legal costs compared to sole proprietorships

Finally, business owners should consider the extra startup and termination costs associated with S Corporations. In general, sole proprietorships and partnerships are easier and less expensive to establish than corporations, so if you're short on funds and want to get your business off the ground immediately, you're probably better off sticking with a more convenient business structure.

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