1. Advantages of an S Corporation
2. Disadvantages of S Corporations
3. Which Companies Can Qualify as S Corporations?

S corp advantages include liability protection, avoidance of double taxation, and the ability to sell shares of stock to raise capital, among other things. An S corporation is a type of corporation that the IRS treats as a pass-through entity. It is created by filing articles of incorporation with the state where it's being formed.

A C corporation protects its shareholders, who are the company's owners, from liability, and so does an S corporation. This means that if there are outstanding debts or litigation, the shareholders' assets cannot be taken to pay for those liabilities. The main difference is that unlike a C corporation, profits and losses are passed through to shareholders. This avoids double taxation because the S corporation is not taxed at the corporate level.

S corporations are not business structures. They are small corporations that choose to be taxed under IRS code Subchapter S. This means businesses that elect to be taxed as S corporations enjoy some of the same benefits of a partnership.

Originally, S corporations were intended as a compromise between heavily-taxed conventional corporations and partnerships, which do not provide shelter from liability. Now that the LLC entity is available, S corporations are not as popular as they once were.

You might consider S corporation status for your business if you intend to keep it small, will only have shareholders that are U.S. citizens or resident foreigners, and won't take out any loans to finance your business. If your plans change, you can always decide to terminate the S corporation election and become a conventional corporation.

Advantages of an S Corporation

Although there are disadvantages to electing S corporation status, the advantages are often more important. These include:

  • Liability protection for shareholders. If there are any outstanding debts or litigation, the shareholders' personal assets are not at risk.
  • Pass-through taxation. All profits and losses are passed through to the shareholders, and the business does not pay taxes on its own behalf.
  • Potential tax reductions due to the way income is characterized. Shareholders of S corporations can be employees and be paid wages. They can also get dividends and profit distributions, which are reported differently and may be taxed at different rates.
  • Ease of ownership transfer. It's a simple matter to sell shares in an S corporation without complicated paperwork or tax issues.
  • S corporations can use the cash method of accounting, while corporations must use the accrual method.
  • S corporations have more credibility with prospective customers, vendors, lenders, and other businesspeople than partnerships or sole proprietors because it is obvious they have made a big commitment to the future of their business.
  • Privacy protection. Many states, particularly Nevada and Wyoming, make it possible for shareholders to remain anonymous.

Disadvantages of S Corporations

Although the advantages are numerous, it's necessary to consider disadvantages as well when making the decision to elect S corporation status:

  • Expenses related to formation and annual maintenance. When the articles of incorporation are filed, there is a fee. Most states also charge annual report fees or franchise tax fees. These are not required by sole proprietorships or partnerships.
  • Requirements that must be followed to remain eligible, such as filing requirements, notification, stock ownership, and annual reports.
  • Restrictions on stock ownership. S corporations can only issue one class of stock, which may discourage investors. They can also have no more than 100 shareholders.
  • IRS scrutiny of the way payments are characterized regarding wages versus dividends. The IRS wants to make sure shareholders are not incorrectly characterizing their income in order to avoid paying taxes.
  • Requirements to comply with the formalities of running a corporation, such as having a board of directors, officers, and regular meetings with written minutes.

Which Companies Can Qualify as S Corporations?

There are limitations on whether or not a company is eligible to become an S corporation. First, all shareholders must be citizens of the United States or permanent residents. S corporation shares may not be held by LLCs or partnerships.

In order to become an S corporation, IRS form 2553 must be filed within 75 days after the tax year begins. If you want to elect S corporation status, we suggest that you consult with an attorney who is familiar with corporate law because the process can be complicated. If done improperly, businesses can lose their S corporation status and the benefits that go along with it.

If you need more information or help to decide if S corporation status is right for your business, 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.