S Corporation Pros and Cons: Everything You Need to Know
An S corporation's pros and cons are mostly related to taxes. Choosing a business entity type will determine how your company is taxed and how the organization is run. 3 min read
2. Personal Service Corporation
3. Pros of S Corporations
4. Cons of S Corporation Status
What is an S Corporation?
An S corporation's pros and cons are mostly related to taxes. Choosing a business entity type will determine how your company is taxed and how the organization is run. There are three popular choices when it comes to determining how to classify your business entity.
- An S corporation
- A Limited Liability Corporation (LLC)
- A C corporation
An S corporation benefits from pass-through taxation, like a partnership or sole proprietorship. This type of taxation only taxes the business on its profits at the individual level. C corporations, however, are taxed at both the corporate and the shareholder level; this is known as double taxation.
Business owners are given the option of how they would like their business taxed, and as long as they meet the eligibility requirements, choosing to structure their business as an S corporation might save them the most on taxes. Along with the break in taxation, business owners also prefer S corporations for the liability protections they provide. S corporations benefit businesses that:
- Provide services, such as consultants
- Do not have significant start-up costs
- Do not require any major purchases, such as equipment to start the operations
- Plan to make a decent amount of money without significant expenses or effort
Once deemed a C corporation, a business can change to an S corporation at a later date, or they can choose to elect status as an S corporation at the start of the new tax year.
Personal Service Corporation
Some corporations will elect S corporation status to avoid being classified as a Personal Service Corporation by the IRS. A PSC is a company that provides services, such as consulting, to the public. In an effort to prevent a loss of revenue, the IRS has closed a loophole to designate C corporations that provide services as PSCs to ensure that they are still taxed at the higher rate. However, for smaller companies that provide a service, it may be in their best interest to elect S corporation status.
Pros of S Corporations
An S corporation is a popular election due to the many benefits that they can create for a company. Some of the benefits that business owners can expect when electing S corporation status include:
- It has income splitting potential with owners and employees.
- Employees can take a salary to be able to pay payroll taxes upfront.
- Business owners will not have to pay the self-employment taxes on the business profits.
- Business owners will be expected to take a reasonable salary for management of the day-to-day operations.
- There is no corporate tax liability for an s corporation as the profits and losses will pass through the individual owner's tax returns.
- An S corporation may have reduced taxable gains in the event that shares are sold.
- You can write off your losses for S corporation, which can be offset against your personal income.
- An S corporation will provide owners with limited liability against debts accrued by the business.
- An S corporation as it can use the cash method of accounting if the business has no inventory.
- You have the ability to raise money by selling stock just as you would with C corporations.
- An S corporation has an unlimited life and can be transferred upon the death or departure of an owner.
It is important to note that some states do not recognize S corporations as a tax status and will treat those companies the same as they would C corporations when it comes to taxation. While this can happen at the state level, the company would not be required to pay federal tax.
Cons of S Corporation Status
While S corporation status may be the best options for your business, it is important to consider the cons before making your final determination.
- Shares can be seized or sold for court proceedings.
- Shares must be directly held.
- If an owner or employee owns 2% or more of the total company shares, they are unable to receive tax-free benefits.
- Due to the pass-through taxation, shareholders in higher income brackets will pay more in taxes.
- If sold, the capital gains on assets are higher than that of limited partnerships or LLCs.
- Due to the limits on the stock, S corporations do not attract as many outside investors.
- The salary requirements may be hard to meet for companies that may be struggling.
If you need help deciding if S corporation status is right for your company, 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.