S-Corp Advantages and Disadvantages: Everything to Know
S-corp advantages and disadvantages are two important areas that business owners need to consider when planning to elect an S corporation.3 min read
Updated November 5, 2020:
S-corp advantages and disadvantages are two important areas that business owners need to consider when planning to elect an S corporation. They should look at these points critically and ensure that they align with their business goals. Nonetheless, electing an S corporation has greater positive opportunities than its drawbacks.
S Corporation: Defined
An S corporation is simply a corporation that has a pass-through concept when it comes to taxation. A corporation filing Form 2553 with the Internal Revenue Services (IRS) can elect an S corporation. It is allowed to issue stocks, has a board of directors, executives, and shareholders with the same functions similar to that of a regular corporation. Shareholders also have liability protection In this manner, personal assets of the shareholders cannot be seized to meet business liabilities.
Like sole proprietors and partnerships, all profits and losses are passed through to the shareholders. Unlike C corporations, which encounter double taxation, S corporations don't settle taxes on the corporate level. Their shareholders pay taxes on the personal level.
Advantages of an S Corporation
As has been mentioned in the first paragraph of this article, the advantages of having an S corporation outweigh any known disadvantages. Sole proprietorship and general partnership offer passed-through taxation, but some of the advantages below are not provided by these business types.
- Protected assets. Shareholders are not responsible for the corporation's business debts and liabilities. S corporation protects all personal assets of the shareholders, and creditors are not allowed to pursue shareholder assets like real estate properties, bank accounts, etc.
- Pass-through taxation. Not all states, but most of them, recognize federal law when it comes to taxation. Since S corporations don't settle taxes on the corporate level, they can avoid double taxation by passing all income and losses to the shareholders who report taxes on their personal income tax returns.
- Characterization of income. Shareholders of an S corporation can also be employees of the company and can receive wages. They can still receive dividends and other distributions that are tax-free to the level of their investment in the business.
- Transfer of ownership. For LLC or partnership, transfer of greater than 50 percent interest can lead to the closure of the business. For S corporations, interests can be transferred freely without corresponding tax penalties.
- Cash method of accounting. Accrual methods of accounting are expected to be utilized by corporations unless they have gross receipts of less than $5,000,000. Meanwhile, S corporations are not required to use these methods except if they have inventories.
- Heightened credibility. With an S corporation making a formal commitment to the business, it is easier for new businesses to establish credibility with potential customers, vendors, partners, and employees.
- Ease of conversion. If the S corporation is terminated, there is no paperwork to be filed since it's only a tax status. On the other hand, LLCs are required to convert to a corporation by submitting needed documents to the secretary of state.
- Room for investors. S corporations are allowed to have at most 100 shareholders.
S Corporation: Disadvantages
Despite these advantages, having an S corporation also has drawbacks. It is suggested that business owners should weigh these pros and cons before formally submitting all documents in electing an S corporation.
- Formation and expenses. Similar to a corporation, an S corporation needs to be formed by filing articles of incorporation with the corresponding payments and reports.
- Tax qualification obligations. Errors and inconsistencies in relation to the election, consent, filing requirements, notification, and even stock ownership, might result in the termination of the S corporation status.
- Calendar year. If the business is unable to provide a business purpose for having a fiscal year, it needs to follow a calendar year as its tax year.
- Stock ownership limitation. S corporations are only allowed to have only one class of stock. The number of shareholders is limited to 100 and only U.S. citizens and residents are allowed to be investors.
- Corporate formalities. Since an S corporation is similar to a regular corporation, it is required to adopt all laws imposed by its home state and any state where it is registered to do business.
- Salary requirements. Owners and officers are required by the IRS to make a salary even if the company hasn't made any profits yet. This could be a challenge to new businesses still struggling to have a payroll.
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