Disadvantages of S Corporation: Everything You Need to Know
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. 3 min read
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: 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: 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: 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.
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.
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