Key Takeaways

  • S corporations have strict ownership and eligibility requirements, including a 100-shareholder cap and citizenship limitations.
  • Formalities such as board appointments, annual meetings, and shareholder recordkeeping can burden small businesses.
  • Distributions must follow strict pro-rata rules, limiting flexibility in profit-sharing.
  • S corporations face unique tax disadvantages, including mandatory salary requirements and taxation on retained earnings.
  • Other disadvantages include complexities in converting back to a C corp, audit risks, and limited deductibility of fringe benefits.

Disadvantages of S corporation types include legal barriers that prevent them from having more than 100 owners or having shareholders that are non-U.S. persons. S corporations are also handicapped by requirements to hold annual meetings and appoint a board of directors. They are constrained by rigid criteria of allocating profits and loss. Moreover, shares or membership in S corporations cannot be held by most partnerships, LLCs, trusts, or other corporations.

What Is an S Corporation?

An S Corporation is a federal tax classification that some corporations and LLCs opt for. The classification enables a corporation to enjoy pass-through status and eliminates the requirement to pay federal corporate tax. Businesses that want to be treated as S corporations file Form 2553 with the IRS. 

Apart from avoiding paying corporate tax, the S corporation arrangement gives a lot of benefits to small businesses, including offering limited liability protection to its owners. The S corporation classification, however, comes with a number of disadvantages. Some of the disadvantages of S corporations are mentioned below.

Disadvantages of S Corporations: Management

  • Strict Management Requirements
    Compared to other small businesses, the S corporation arrangement has a rigid management structure. The corporation must appoint a board of directors and officers and hold formal management meetings as well as annual shareholders meetings. This can end up eating into the resources of a small business.
  • Annual Fees and Taxes
    S corporations in most states file documents annually with the state and pay a filing fee. In some states, S corporations are required to pay a minimum franchise tax “for the privilege of doing business” in the state. Such requirements do not apply to sole proprietorships and general partnerships.
  • Taxation Calendar
    Corporations are required by the IRS to follow the calendar year as the tax year. Many other entity types have the freedom to choose any tax year type.

Disadvantages of S Corporations: Increased IRS Audit Risk

S corporations are more likely to be audited by the IRS than sole proprietorships or partnerships, particularly concerning how compensation is split between salary and distributions. If the IRS deems the salary too low, it may reclassify distributions as wages, triggering back taxes, interest, and penalties.

Disadvantages of S Corporations: Ownership Restrictions

S Corporations have the following restrictions on ownership:

  • An S corporation can not have more than one class of stock. In practice, this curtails the corporation's ability to seek funding and to grow.
  • S corporations cannot have more than 100 shareholders.
  • All the shareholders of an S corporation have to be U.S. citizens, or at least U.S. residents.
  • With just a few rare exceptions, shares of an S corporation cannot be held by other corporations, LLCs, partnerships, or trusts. This limits options for getting funding.

Disadvantages of S Corporations: Shareholder Compensation Rules

The IRS scrutinizes S corporations to ensure that shareholder-employees receive a "reasonable salary" before profits are distributed as dividends. Determining what constitutes a reasonable salary is often subjective and may expose businesses to audits or penalties. This creates added stress for small business owners trying to balance growth and compliance.

Disadvantages of S Corporations: Distributions

  • Shares of S corporations' shareholders can be seized and sold through court action. Such actions might be difficult with the other small business entity types.
  • Earnings or losses can only be distributed based on the number of shares of the owner. General partnerships and LLCs, on the other hand, can come up with alternative criteria to determine distribution. This constraint for s corporations does not favor businesses with active and non-active owners or businesses made for estate planning. 

Disadvantages of S Corporations: Limited Deductibility of Fringe Benefits

S corporation shareholder-employees who own more than 2% of the company face limitations in deducting fringe benefits such as health insurance, group-term life insurance, and cafeteria plans. These benefits are often taxable to the shareholder, making S corps less attractive than C corporations for those seeking to maximize tax-free employee perks.

Disadvantages of S Corporations: Converting Back to a C Corporation

Switching from an S corporation back to a C corporation is neither simple nor without tax consequences. Once an S election is terminated, a business typically cannot re-elect S corporation status for five years. Additionally, any appreciated assets distributed during the change may trigger built-in gains tax, creating unexpected tax liabilities for shareholders and the business.

Disadvantages of S Corporations: Taxes

Most people only imagine tax advantages when they think of S corporations. However, the S corporation arrangement can bring some tax disadvantages as well, including:

  • Arbitrary Taxation
    The income of an S corporation's shareholder is taxed whether it is distributed out to the shareholders or reinvested. This is not the case for C corporations.
  • Salaries
    In an effort to prevent s corporation owner-employees from dodging employee taxes, the IRS forces S corporations to pay “reasonable” salaries to all employee-shareholders and of the corporation. This requirement applies regardless of whether the company is making a profit or not. This can stifle the growth of a new S corporation.
  • Sale of Assets
    For assets that appreciate in value with time, the capital gains from the sale are generally higher if the business is an S corporation as compared to other small business types.
  • Fringe Benefits
    All employees who are shareholders and own at least 2 percent of the S corporations will incur taxes on benefits like health insurance. It is easier to circumvent this tax with a C corporation.

The S corporation is a very popular business type with small business owners. It enables businesses to enjoy many benefits of corporations without being subjected to double taxation. The S corporation arrangement was, however, designed to benefit a particular group of business owners. Its benefits need to be carefully analyzed against its potential limitation in the areas of ownership, management structure, and taxes.

Disadvantages of S Corporations: Administrative Complexity

In addition to tax burdens, administrative complexity is a significant drawback for many small businesses that elect S corporation status. Owners must ensure compliance with corporate formalities such as issuing stock, maintaining shareholder records, and documenting board resolutions. Failure to observe these requirements could result in the loss of S corp status. S corporations are also more likely to need professional legal and tax assistance, increasing operational costs.

Frequently Asked Questions

  1. What is the biggest disadvantage of an S corporation?
    One of the most significant disadvantages is the strict eligibility and ownership rules, which limit growth and investment flexibility.
  2. Can S corporations reinvest profits without distributing them?
    Yes, but shareholders must still pay taxes on their share of the profits, even if the profits are not distributed.
  3. Why are S corporations subject to more IRS scrutiny?
    The IRS closely examines how S corporation owners split income between salary and distributions to ensure employment taxes are correctly paid.
  4. What happens if an S corporation violates eligibility rules?
    If an S corporation violates rules (e.g., having an ineligible shareholder), it risks termination of its S election and will be taxed as a C corporation.
  5. Can I switch back to a C corp from an S corp easily?
    Switching back is possible but complicated and may trigger built-in gains tax. Re-electing S status typically requires waiting five years.

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