Key Takeaways

  • S Corps offer tax benefits but come with restrictions on ownership, stock structure, and operations.
  • Common disadvantages of S Corps include stricter IRS compliance, limits on shareholders, and less flexibility than LLCs.
  • S Corps require ongoing administrative formalities such as meetings, recordkeeping, and annual reports.
  • The IRS closely monitors shareholder compensation, which can create additional scrutiny and potential tax reclassification.
  • Not all states recognize S Corp status the same way—some impose separate taxes or fees.
  • S Corps can lose their tax status if eligibility rules are violated, resulting in unexpected tax liabilities.

There are several S Corp disadvantages that you need to consider before electing this tax status with the IRS.

What Is an S Corporation?

The corporate structure you choose will depend on the sort of business that you are running, as well as your shareholder's long-term and short-term goals. For federal tax purposes, S corporations are treated as pass-through entities. You can receive this tax treatment after electing S corporation status with the IRS. With an S corporation, just like with other corporations, you will be required to file Articles of Incorporation with your Secretary of State.

If you form an S corporation, corporate losses and profits will be allocated to shareholders. This avoids the double taxation that applies to other corporations. S corporation shareholders will be taxed individually on the income that is passed to them by the company. Business owners prefer S corporations because of their single taxation and their limited liability protections.

S Corporation Disadvantages

In certain circumstances, the advantages of an S corporation can become disadvantages depending on the needs of your business. For instance, S corporations are much less flexible than limited liability companies in terms of operations.

The biggest disadvantage of an S corporation is that the incorporation process can cost you time and money. Incorporating an S corporation requires:

  • Filing Articles of Organization
  • Finding a registered agent for your corporation
  • Paying state required fees

Additional Expenses

Some states may also require you to pay ongoing fees such as a franchise tax or annual report, adding to your expenses. Even though these fees are deductible, and they aren't that expensive, they don't apply to other business structures.

Corporate Formalities

Another drawback of an S corporation is that they are required to observe corporate formalities. For example, S corporations are required to file a large number of official documents, which can include corporate minutes. S corporations must also hold shareholder meetings on a regular basis and need to pay all government fees.

Loss of S Corporation Status

Due to the complicated requirements or notification, stock ownership, election, and consent, it's possible for a corporation to lose its S corporation tax states. Losing S corporation status is usually fixed very easily, and happens rarely, but it is still a drawback of this corporate structure that needs to be considered.

Calendar Restrictions

S corporations must use a calendar year instead of a fiscal year unless they can prove a good reason for doing otherwise.

Stock Ownership

There are also restrictions on stock ownership for S corporations. For starters, there is only one class of stock. In effect, this means that S corporations cannot have different investor classes. S corporations are also limited to 100 or fewer stockholders, and there can be no foreign ownership of stocks. Stock ownership by entities such as trusts is also restricted.

IRS Scrutiny

Because both salaries and dividends can be distributed to S corporation shareholders, the IRS pays close attention to payments to make sure they are being characterized truthfully. It is possible that the IRS will re-characterize wages, choosing to treat them as dividends instead. This will result in your corporation losing a compensation paid deducted. The IRS may also decide to characterize dividends as wages, which may mean your corporation will be liable for the employment tax.

Lack of Flexibility

In terms of distributing losses and income, S corporations are considerably less flexible than other business structures. Because S corporations are limited to one class of stock, it can be difficult to distribute income and losses to a specific shareholder. In an S corporation, distribution is determined by stock ownership. This differs from LLCs and partnerships, where an operating agreement can be used to allocate losses and income.

Administrative and Compliance Burdens

While S Corps provide pass-through taxation, they also face significant compliance requirements. Business owners must maintain detailed corporate records, hold annual shareholder and director meetings, and document major business decisions. Failure to meet these obligations can jeopardize the company’s good standing with the state and even risk losing its S Corp election.

In addition, S Corps must file Form 1120-S annually and provide Schedule K-1 forms to shareholders. This extra paperwork adds time and cost compared to an LLC or sole proprietorship, where tax filings are typically simpler. The increased administrative oversight makes S Corps less attractive for smaller businesses that lack in-house accounting support.

State-Level Tax Complications

Another major disadvantage of S Corps is the inconsistency in how states treat this entity type. While the IRS recognizes S Corps federally, not every state follows suit. Some states, such as California and New York, impose franchise taxes or additional fees even on pass-through S Corps. This means owners may pay state-level taxes similar to C corporations, reducing the expected tax savings.

Additionally, certain states require separate state-level S Corp elections, and missing these filings can result in the business being taxed as a C corporation at the state level. Entrepreneurs should verify state-specific requirements before filing for S Corp status to avoid double taxation.

Ownership and Stock Restrictions

S Corps are restricted to 100 or fewer shareholders, and all must be U.S. citizens or resident individuals—foreign investors, partnerships, and most trusts are not eligible. Moreover, S Corps may only issue one class of stock, limiting the ability to structure equity creatively or attract investors through preferred shares.

These ownership limitations make S Corps less flexible for growing companies or those seeking venture capital. By contrast, C corporations can issue multiple stock classes and have unlimited shareholders, making them more suitable for scaling and investment.

Increased IRS Oversight of Compensation

One of the most misunderstood disadvantages of S Corps is the IRS scrutiny over owner compensation. Since shareholder-employees can receive both salaries and dividends, some business owners attempt to reduce taxable income by taking a smaller salary. However, the IRS requires “reasonable compensation” based on industry standards.

If the IRS determines that wages are unreasonably low, it can reclassify distributions as wages, resulting in additional payroll taxes, penalties, and interest. To avoid issues, S Corp owners should maintain documentation supporting their salary levels relative to their role and company profits.

Limited Flexibility in Profit Distribution

Unlike LLCs, which can allocate profits and losses based on ownership agreements, S Corps must distribute earnings strictly in proportion to share ownership. This limitation means that even if some shareholders contribute more labor or capital, they cannot legally receive a disproportionate share of profits.

For example, if two shareholders each own 50% of the business, both must receive equal distributions—even if one works full-time and the other is passive. This rigid structure can cause conflicts among owners and make S Corps less adaptable for partnerships with uneven contributions.

Difficulty in Attracting Investors or Retaining Profits

Because of ownership and stock limitations, S Corps often struggle to raise external capital. Venture capital firms, institutional investors, and foreign partners typically prefer C corporations, which allow multiple stock classes and flexible equity arrangements.

Moreover, S Corps cannot easily retain earnings for growth. Since profits are passed through and taxed to shareholders each year, owners may owe taxes on income not yet distributed. This can create cash flow challenges for growing businesses that want to reinvest profits rather than distribute them immediately.

Loss of S Corporation Status

Violating S Corp eligibility rules—such as exceeding the shareholder limit or inadvertently transferring stock to an ineligible owner—can cause automatic termination of S Corp status. Once revoked, the entity becomes a C corporation and is subject to double taxation until reinstated.

Reinstatement requires IRS approval and may take several months. During that time, the business is taxed differently, which can disrupt financial planning and increase tax liabilities. Careful recordkeeping and shareholder management are crucial to maintaining compliance.

S Corporation Advantages

The advantages you can receive from electing S corporation status more than makeup for any potential disadvantages. For instance, if you need to discontinue your business or are interested in transferring ownership, structuring your business as an S corporation makes these processes much easier. You generally won't receive these benefits when choosing a sole proprietorship or general partnership as your business structure.

S corporations also provide liability protections to their shareholders. These limited liability protections are also available to C corporations and LLCs. Unless there is a personal guarantee in place, S corporations shareholders cannot be held liable for the company's debts. This means that when a creditor sues the company for an unpaid debt, they cannot pursue the personal assets of shareholders, including:

  • Bank accounts
  • Houses
  • Cars

With a partnership or sole proprietorship, the owners of a business are personally liable for any and all company debts, as the owner and their company are legally inseparable.

When S Corps May Not Be Ideal

S Corps work best for established small businesses with consistent profits and active shareholders. However, they are less suitable for startups seeking rapid growth, companies with international ownership, or those needing flexible profit-sharing arrangements.

If your business expects to bring on new investors, issue multiple stock types, or retain large profits for expansion, a C corporation or LLC may be a better fit. Consulting a business attorney or CPA before electing S Corp status can help you avoid costly restructuring later.

Frequently Asked Questions

  1. What are the main disadvantages of an S Corp?
    The main disadvantages include ownership restrictions, limited stock flexibility, additional compliance requirements, and increased IRS scrutiny over salaries.
  2. How many shareholders can an S Corp have?
    An S Corp can have up to 100 shareholders, all of whom must be U.S. citizens or resident individuals.
  3. Can an S Corp have foreign investors?
    No. Non-resident aliens, partnerships, and most trusts are not eligible to own S Corp stock.
  4. Why does the IRS review S Corp salaries?
    The IRS ensures shareholder-employees receive “reasonable compensation” to prevent underreporting of payroll taxes.
  5. Do all states recognize S Corp status?
    Not all states treat S Corps the same way. Some impose franchise or income taxes even on federally recognized S Corps, reducing potential tax savings.

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