S Corporation Advantages: Everything You Need to Know
There are many S corporation advantages for your business. 3 min read
2. Which Companies Can Qualify as S Corporations?
3. Advantages of an S Corporation
4. Disadvantages of an S Corporation
There are many S corporation advantages for your business. The term S corporation or S corp gets its name from the IRS S election, a type of taxation which requires that shareholders pay taxes at the individual level. This allows the business to avoid the double taxation it would be subject to as a regular corporation.
What Is an S Corporation?
To further define the concept, an S corporation is a regular corporation treated as a pass-through entity under federal tax rules and is elected through the Internal Revenue Service (IRS). S corporations don't pay taxes at the corporate rate. Instead, profits and losses are passed through to shareholders who report these on their personal income tax returns.
Forming an S corporation is similar to forming an ordinary corporation with an Article of Incorporation submitted to the Secretary of State or similar agency. Business owners have the same liability protection as shareholders of a regular corporation. Shareholders' personal assets can't be seized to satisfy business debts and liabilities.
Which Companies Can Qualify as S Corporations?
There are a few requirements that have to be met before a business can get S corporation status. The business must demonstrate that:
- Shareholders are permanent residents or hold U.S. citizenship
- There are no more than 100 shareholders
- It only has one class of stock
If your business can satisfy these criteria and you are considering converting it to an S corporation, take note of the deadlines for processing your application with the IRS. When forming a new business, you are only allowed to file IRS Form 2553 within 75 days from the date of incorporation.
Advantages of an S Corporation
- Shareholders' personal assets are protected.
- Federal taxes are not paid on the corporate level, saving the business from possible double taxation.
- Shareholders can also be employees of the business which means they can receive salaries apart from their dividends and other tax-free distributions.
- An S corporation can easily be converted into a C corporation.
- Shareholders and management are covered by limited liability protection.
- There are no state residency requirements.
- S corp status allows for pass-through taxation which means that income is distributed to the shareholders, where tax payment is applied at the personal level.
- There is stronger credibility with customers, partners, investors, lenders, and employees as an S corp when compared to sole proprietorships.
- There is high income-splitting potential for shareholders and employees.
- S corp status doesn't require large start-up costs or major equipment purchases and contracts.
Disadvantages of an S Corporation
On the other hand, there are also disadvantages and risks involved in having a business registered under S corporation status.
- For an S corporation to operate, the business needs to be incorporated. This requires filing Articles of Incorporation in the desired state, getting a registered agent, and paying the necessary fees.
- Mistakes related to the business structure like elections, stock ownership, notification, consent, and other filing requirements can result in a cancellation of S corporation status.
- An S corporation is mandated to use the calendar year as its tax year unless it can propose a business purpose for following a fiscal year model.
- S corporations are only allowed to offer one class of stock. There can be no more than one class of investors.
- The number of shareholders is limited to 100, which can limit growth.
- Foreign ownership is not allowed, and there are a lot of rules concerning ownership of trusts and other entities.
- S corporation accounting can be more involved and require greater legal oversight when compared to sole proprietorships.
- Fringe benefits offered by the corporation to employee-shareholders who hold more than 2 percent of the corporation are subject to tax.
- Because of the one-class stock requirement, income or losses are difficult to allocate to specific shareholders.
Having a business established under S corporation status has advantages and disadvantages. It is better for business owners to examine all of these factors in order to maximize income for their business.
If you need help with S corporation filing, or want to discuss the pros and cons of S corp status, 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.