S Corporation Ownership: Everything You Need to Know
S corporation ownership is something that has been considered by many business owners and potential business owners, mainly due to the benefits it can offer in relation to taxes. 4 min read
2. S Corporation Advantages
3. S Corporation Disadvantages
What is an S Corporation?
S corporation ownership is something that has been considered by many business owners and potential business owners, mainly due to the benefits it can offer in relation to taxes. S corporations are corporations that elect to be treated as pass-through entities for tax purposes by the IRS, which means that taxes are passed through from the corporate to individual level and owners are only taxed on the individual level, thus avoiding double taxation. This is done to encourage the growth of small businesses, who commonly use this business form for this very reason.
S corporations are often considered to be the light version of a C corp, since other than their tax situation, they are mostly the same. They must file Articles of Incorporation with the Secretary of State. They issue stock and are governed by shareholders, directors, and officers. They enjoy the same limited liability protection and offer the same perpetual existence. In fact, they start off as C corporations to begin with, until one files Form 2553 with the IRS to take the S corporation election.
For small business owners especially, there are many advantages to an S corporation election. These include:
- Limited liability. This means that the owners of an S corporation are protected from their personal assets being liable for the satisfaction of debts or legal rulers that are related to their business. Business assets will be fair game, but in most cases, personal ones, such as property and bank accounts, will not be.
- Pass-through taxation. Having this type of taxation means that one does not pay taxes at the corporate level. This tax situation usually also applies at the state level, as well.
- Tax favorable income characterization. If an owner works for their S corporation, they can first take a portion of their income as a salary, and then take the rest in the form of a distribution. The distribution portion is not subject to FICA taxes, which can yield considerable savings. However, the salary portion must be reasonable to the job that is done—the IRS checks for abnormally low salaries.
- Simple ownership transfer. To transfer S corporation ownership, one can simply sell their shares. In contrast, if one were in a partnership or LLC, transferring over half of their interest could trigger the dissolution of their business entity.
- Cash accounting. S corporation may use the cash method of accounting unless they posses inventory. C corporations, on the other hand, must use the accrual method, unless they have less than $5,000,000 in gross receipts.
- Increased credibility. S corporations are often perceived as being more credible by potential employees, customers, partners, and vendors because operating one is seen as being a greater commitment on the part of the owners.
S Corporation Disadvantages
- Complexity and expense of formation. Forming an S corporation is a more complex and expensive undertaking than forming some other business types. To form an S corporation, Articles of Incorporation must be filed, a board of directors as well as other corporate positions must be selected, and various one-time and ongoing fees must be paid. If one were to form a partnership or sole proprietorship, these fees and most start-up procedures would not apply.
- Document filing procedures. If certain mistakes are made in the filing of various consent, election, stock ownership, notification, and tax documents, the S corporation could be terminated as a result. This can usually be reversed and is not a common occurrence, but it is an inconvenience that other business forms do not have to deal with.
- Calendar year. S corporations must use the calendar year as their tax year, unless they can show they have a legitimate business reason to use the fiscal year. Some may find this inconvenient.
- Ownership restrictions. S corporations can only have one stock class, so there can only be one level of ownership. Also, there can only be 100 or less S corporation owners, they must be U.S. residents, and they cannot be LLCs, other corporations, partnerships, or many other types of trusts.
- Increased IRS scrutiny. Because of the possibility of abuse of the tax-free distributions, the IRS will be taking a closer look at an S corporation’s finances.
- Less flexibility related to loss and income allocation. Being restricted to only one stock class also restricts how losses and income can be distributed, since stock ownership governs this. Partnerships and sole proprietorships do not have this problem, and can determine allocation in their operating agreements.
These are just some of the advantages and disadvantages of S corporation ownership. If you need help further understanding S corporation ownership, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.