S Corp Pros and Cons: Everything You Need to Know
There are S corp pros and cons to consider before choosing a business structure.3 min read
There are S corp pros and cons to consider before choosing a business structure.
The pros are:
- No corporate tax
- Lessens taxable gains
- Ability to write off start-up losses
- Liability protection
- Selling stock
- Saving on payroll taxes
The cons are:
- One class of stock
- Not as desirable for outside investors
- Tax filing
- Corporate meetings
- State filings
- Ownership restrictions
Pros of Choosing an S Corp
No Corporate Tax: Perhaps the main reason why people incorporate as an S corp is its tax advantages. Unlike a C corp wherein the profits and losses are taxed at the corporate level and again at the personal level, an S corp’s profits and losses “pass through” to shareholders personal income tax. This tax structure is similar to an LLC, where pass-through taxation avoids double taxation.
Lessens Taxable Gains: When the business is sold, which can be a retirement strategy, an S corp may have reduced taxable gains.
Ability to Write off Start-up Losses: When a business initially launches, there will be many expenses. Such business expenses can be offset against a shareholder’s personal income. In contrast, a regular corporation’s initial losses would be locked within the company, with no relevance to personal income.
Liability Protection: As a corporation, there is personal liability protection. Note, however, that liability protection does not equal total protection. Shareholders can be held personally liable for their actions.
Selling stock: To raise capital, an S corp can sell shares. Since ownership is based on shares, the business is perpetual, continuing to exist regardless of what happens to an individual owner or director.
Saving on payroll taxes: When a shareholder in an S corporation is actively involved in the business, then he or she wears two hats as employee and owner. As a rule, a corporation is required to withhold and pay Medicare and Social Security payroll taxes on behalf of its employees, per IRS rules. Distributions to employees, however, are not taxed this way because those taxes are payroll taxes.
The result is that the more revenue received by an employee who is a shareholder, in a shareholder capacity, the less Social Security and Medicare taxes. Note that the IRS scrutinizes such salary v. distribution allocation closely given the potential for misappropriation of distribution/salary. Therefore, anyone considering an allocation for an employee/shareholder should make sure that the distribution portion v. salary portion ratio is reasonable relative to the industry.
S Corporation Cons
One Class of Stock: Being an S Corporation limits issuing shares to only one class of stock. The inability to issue various classes of stock means that a business holds less control on the company and limits stock value.
Not as Desirable for Outside Investors: A startup needs money. To secure venture capital, a regular corporate structure will be more attractive as an investment target. A venture capitalist will likely not want to invest in a pass-through tax entity or see a limit of 100 shareholders.
Tax Filing: As opposed to a non-corporate structure, S corps will avoid corporate taxes but is still required to file a yearly tax return.
Corporate Meetings: Although tax treatment is different, it is still a corporation with requirements of having regular meetings and transcribing company minutes.
State Filings: In contrast to simpler entity types, an S corp is created by state regulation wherein someone files an Articles of Incorporation or a Certificate of Incorporation with the local Secretary of State and pays a prescribed filing fee. There is a yearly requirement that a corporation pays a fee to and files an annual report.
Ownership restrictions: Although an S corporation may issue any amount of shares of stock and divide that stock any number of ways amongst the various shareholders, the issuance is legally capped at 100 total shareholders. Those shareholders of the S corp, 100 or fewer, are required to be either U.S. citizens or recognized permanent residents. In addition, certain qualified trusts and estates are permitted to be shareholders. Unlike C corps, an S corp can issue just one class of stock.
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