S Corporation Advantages and Disadvantages: Everything You Need to Know
S corporation advantages and disadvantages may be beneficial for you when deciding on how to form your company.3 min read
S corporation advantages and disadvantages may be beneficial for you when deciding on how to form your company. An S corporation is one of many corporations choice that you can elect that allows your corporation to be treated as a flow-through entity.
As a flow-through entity, the S corporation doesn't pay any taxes on income at a corporate level. All profits and losses from the business are passed onto the shareholders who file the amounts on their personal income tax returns. This is beneficial when tax time rolls around.
In order to get established as an S corporation, the creator needs to file Articles of Incorporation with the Secretary of State or relevant authority. An S corporation will look similar to a C corporation as they:
- Need to have directors, officers, and owners in place
- Shareholders have protection from any business liability
How To Start An S Corporation
Just because a business wants to become an S corporation, it doesn't mean they can be. There are a few regulations in place by the Internal Revenue Service.
- All shareholders must be U.S. citizens or permanent residents. That means an LLC cannot be a shareholder of the S corporation.
- There can be no more than 100 shareholders.
If you meet the above criteria and are interested in becoming an S corporation, there is a deadline to apply with the IRS. New businesses have 75 days to file as an S corporation from the date of incorporation. The relevant form is IRS Form 2553.
S Corporation Advantages
An advantage of both profit and losses from the business being passed onto the shareholder is that losses can potentially offset other income on the personal income tax returns.
If a shareholder wants, they can be an employee of the S corporation and receive a salary as any other employee would. That salary is in addition to dividends and other tax-free distributions generated by the corporation.
Changing corporation types isn't easy, but an S corporation has some flexibility as it simply means making a federal tax election. If the election is forgone, there is no further paperwork needed and the S corporation is terminated. On the other hand, terminating an LLC requires paperwork to be submitted, potentially to many different places.
Transferring shareholder ownership of an S corporation is relatively straightforward with no tax consequences.
In most scenarios, an S corporation holds no inventory. This means for accounting purposes they can use the simple accounting method, rather than the accrual method dreaded by corporations around the world.
If a new business elects to operate as an S corporation, you may establish credibility with potential stakeholders as this election takes a formal commitment.
S Corporation Disadvantages
Although rare, there are mistakes that can lead to the termination of an S corporation. This may be in regards to elections, consent, stock ownership, and filing requirements. Fortunately, in most cases, mistakes can be remedied.
Unless there's a legitimate reason for having a fiscal year, all S corporations must adopt a calendar year for their tax year.
S corporations can only issue one class of stock, regardless of who the shareholders are. This is a benefit of LLCs where all the class stocks are mentioned in the organization documents.
No foreign ownership is allowed if you're electing to be taxed as an S corporation. That also goes for trusts and other types of entities looking to avoid double taxation.
Any amounts distributed to shareholders could be in the form of dividends or salary. Therefore the IRS will check payments to make sure reality matches real life. In some cases, wages may be recharacterized as dividends in which case the corporation loses a deduction for compensation paid.
S corporations cannot issue losses to some shareholders and income to others as there's the one class of stock restriction.
If a corporation provides fringe benefits, they're usually taxable for employee-shareholders who own more than 2 percent of the corporation.
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