S Corporation Disadvantages: Everything You Need to Know
There are some S corporation disadvantages you should know before electing an S status for your corporation. 3 min read
There are some S corporation disadvantages you should know before electing an S status for your corporation. Find out everything you need to know about the advantages and disadvantages of an S corporation before making a choice about which type of corporation is right for your company.
What is an S Corporation?
S corporations are pass-through tax entities that do not pay federal taxes at the corporate level. Instead, they pass most of their income and losses to shareholders who then claim them on their personal income taxes. In this way, S corporations are similar to sole proprietorships or partnerships. Unlike traditional C corporations, S corporations avoid the double taxation that happens when companies pay taxes at the corporate level and again at the individual level.
Just like a C corporation, an S corporation issues stock and has officers, directors, and shareholders who govern the corporation. To create an S corporation, you must file Articles of Incorporation with the secretary of state or similar government body in the state where you want to set up the corporation.
Advantages of an S Corporation
There are many reasons why companies elect an S status. Some of the advantages of an S corporation include:
- Protecting shareholders from having their personal assets, such as bank accounts, seized to pay business liabilities
- Using business losses to offset a shareholder's other income on their personal tax returns
- Paying a shareholder a salary as an employee of the company in addition to dividends and other tax-free distributions relative to the shareholder's investment
- Being able to easily convert to a C corporation by making a simple federal tax election instead of the complex document filing process a limited liability company (LLC) goes through to make the same change
- Transferring interests freely without facing a negative tax impact or needing to make property adjustments or comply with accounting rules
- Avoiding use of the complex accrual method of accounting if there is no inventory involved
- Establishing credibility with employees, customers, vendors, and partners who feel there is less risk in working with a new company due to your formal commitment to the business
Disadvantages of an S Corporation
While there are many pros to electing an S status for your corporation, there are also many cons. The disadvantages include:
- Making errors with the corporation's election consent, stock ownership, notification, and filing requirements that, though rare and easily fixed, end in S status termination
- Choosing a calendar year instead of a fiscal year as a tax year unless there is a solid business reason
- Having only one class of stocks and investors with equal dividends and distribution rights
- Having a maximum of 100 shareholders who are U.S. citizens or permanent residents
- Being subject to Internal Revenue Service (IRS) scrutiny about shareholder salaries and dividends that sometimes results in wage recharacterization as dividends and a deduction for compensation paid
- Making it difficult to allocate losses or income to certain shareholders since stock ownership governs an S corporation instead of an operating agreement
- Paying taxes for corporate fringe benefits, such as health and life insurance, if you own more than 2 percent of the company
When registering with the IRS, there are extra steps an S corporation needs to take. Before a company files for S status, it must become a corporation. The company needs to have at least one shareholder, and each shareholder needs to sign IRS Form 2553. If the form is not filed within two months and 15 days of the start of the tax year, the company will not receive its S status that year. The company can file again after waiting a full tax year.
S corporations risk losing their S statuses if they do not follow strict operating requirements. These requirements include:
- Having scheduled meetings for directors and shareholders
- Keeping detailed minutes of meetings
- Recording company bylaw updates and adoptions
- Maintaining detailed records
- Reporting stock transfers
When making a choice about which status is best for your corporation, make sure you understand both the pros and cons of each type. While an S status may seem like the right choice for your company due to its many benefits, understanding S corporation disadvantages helps ensure you make the right decision.
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