S Corporation Benefits and Disadvantages: Everything You Need to Know
An S corporation is a form of corporation that's taxed as a flow-through entity for Federal tax purposes. 3 min read
What are the benefits and disadvantages of an S corporation? An S corporation is a form of corporation that's taxed as a flow-through entity for Federal tax purposes. The S election means shareholders are taxed at an individual level only unlike a C corporation where they get taxed at both corporate and individual levels.
With no federal taxes paid at the corporate level, all S corporation profits/losses are passed to the shareholders who file the dividends/earnings on their personal tax income returns.
An S corporation is created by filing Articles of Incorporation with the Secretary of State or similar governing body. The S corporation issues stock and is governed by directors, officers, and shareholders similar to a C corporation. This also means an S corporation shareholders personal assets cannot be seized to recover business liabilities.
Who Can Qualify To Be An S Corporation
- S corporation shareholders must be U.S. citizens or permanent residents
- There is a maximum of 100 shareholders allowed in an S corporation
The biggest benefit of an S corporation is that a shareholder's personal assets are protected. All shareholders can be employees of the business, and earn a salary in addition to receiving dividends, and other tax-free distributions.
For individuals, the S corporation issues profits/losses that haven't been taxed at a corporate level as the S corporation acts as a 'pass-through' entity. Therefore any losses can offset other income sources on an individuals tax returns.
An S corporation can convert to a C corporation more fluidly than an LLC as it just requires a Federal tax election change. An LLC would require a formal procedure with documents filed with the Secretary of State in the LLC's formation state and every state where it has qualified to do business.
S Corporation ownership interests are easily transferred to shareholders. No tax consequences are triggered or any other weird accountancy issues are involved when ownership interest is transferred.
S corporations don't have to apply the accrual method of accounting in most scenarios unless they have inventory.
By making a commitment to being an S Corporation you gain credibility as a new business with customers, employees, vendors, and partners.
Other advantages of forming an S Corporation are the ability to have any number of management, with no state residency requirements. If you're looking to incorporate in Nevada and Wyoming, you have especially good privacy protection.
In general, S corporations are really suited for businesses that:
- provide a service
- have minimal start-up costs
- make a sizable amount of money without extensive effort and expense
S Corporation Disadvantages
There are formal procedures to follow to get started with an S corporation. You need to:
- Incorporate by filing Articles of Incorporation
- Obtain a registered agent for your company
- Pay Fees
An S corporation status can be terminated with mistakes regarding various elections, consent, notification, stock ownership and filing requirements. In most cases, the termination can be remedied but this isn't a factor in other business types.
With a maximum of 100 shareholders (voting and non-voting shares), S corporations can have only one class of stock meaning investors cannot be entitled to different dividend and/or distribution agreements. This is not the case for a partnership or an LLC that can allocate profits and losses based on the operating agreements.
Foreign ownership of S corporations is prohibited, as is ownership by some types of trusts and other entities.
Most S corporation fringe benefits are taxed as compensation to employee-shareholders with or 2+ percent ownership.
An S corporation needs to consider the additional startup and termination costs that are more than a simple sole proprietor and partnership.
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