S Corp Advantages and Disadvantages Explained Clearly

Key Takeaways

• S corporation advantages include pass-through taxation, limited liability protection, and the ability to avoid double taxation.
• Shareholders can receive both a reasonable salary and dividend distributions, reducing self-employment tax burdens.
• Disadvantages include stricter ownership rules, IRS scrutiny over reasonable compensation, and limitations on stock classes and shareholders.
• S corp status suits small to mid-sized businesses that want corporate protection but partnership-style taxation.
• Not all states recognize S corp status for tax purposes; some may still impose corporate-level taxes.

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.

Additional S Corp Advantages Beyond Tax Savings

While pass-through taxation is the primary reason businesses elect S corporation status, there are several other S corp advantages that can strengthen a company’s financial and legal standing:

1. Reduced Self-Employment Taxes:
   Unlike sole proprietorships or partnerships, S corporation owners can split income between salary and dividends. Only the salary portion is subject to Social Security and Medicare taxes, which may result in significant tax savings.
2. Enhanced Credibility and Professionalism:
   Operating as an S corporation may increase your company’s credibility with customers, lenders, and investors, demonstrating a higher level of organization and accountability.
3. Limited Liability Protection:
   Like C corporations and LLCs, shareholders are generally not personally responsible for business debts or legal obligations. This protection separates personal and business assets, shielding owners from most business-related lawsuits or claims.
4. Ease of Ownership Transfer:
   Shares in an S corporation can be transferred without triggering complex tax consequences or the need to dissolve the entity—making succession planning easier.
5. Simplified Accounting Options:
   S corporations that do not hold inventory may use the cash method of accounting, simplifying bookkeeping and cash flow management.
6. Potential State Tax Advantages:
   Some states extend favorable tax treatment to S corporations, reducing or eliminating franchise taxes for qualifying small businesses.
7. Perpetual Existence:
   An S corporation continues to exist independently of ownership changes, ensuring business continuity if a shareholder dies or exits the company.

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.

Additional S Corp Disadvantages to Consider

Despite the benefits, S corporation status comes with limitations and compliance requirements that may not suit every business:

• Eligibility Restrictions:
  S corporations are limited to 100 shareholders, all of whom must be U.S. citizens or residents. Other corporations, LLCs, partnerships, and many trusts cannot own shares.
• One Class of Stock:
  S corporations can only issue one class of stock, which may restrict their ability to attract investors or issue preferred shares.
• IRS Scrutiny Over Salaries:
  The IRS requires S corp owners who perform substantial services to receive a “reasonable salary.” Underpaying oneself to reduce payroll taxes can lead to audits or penalties.
• Increased Administrative Burden:
  S corporations must maintain corporate bylaws, hold regular meetings, record minutes, and file informational tax returns. This makes them more complex than sole proprietorships or simple LLCs.
• Uneven State Tax Treatment:
  Some states, such as California and New York, impose additional franchise or excise taxes on S corporations even though they are exempt from federal corporate taxes.
• Distribution Rules:
  Profit distributions must be proportionate to ownership percentages, limiting flexibility in how income is allocated among shareholders.
• Less Flexibility for Growth:
  Because of stock and ownership limitations, S corporations often face challenges in raising capital compared to C corporations.

When an S Corporation Might Be the Wrong Choice

Certain business structures or operational needs may make S corp election less advantageous:

• High Reinvestment Needs:
  Businesses that plan to reinvest most profits into growth rather than distribute them may prefer C corporation status, which allows more flexibility in profit retention.
• Multiple Classes of Investors:
  Companies seeking venture capital or institutional investors typically need the ability to issue preferred stock, which S corporations cannot do.
• Multistate Operations:
  If your business operates in several states, differing state tax treatments for S corporations can create compliance headaches and inconsistent obligations.
• Foreign Ownership:
  If you expect to add nonresident alien shareholders, your business will become ineligible for S corporation status.

Frequently Asked Questions

1. What are the main S corp advantages for small businesses?
   The main advantages include pass-through taxation, limited liability, potential payroll tax savings, and enhanced credibility with lenders and clients.
2. Can an LLC elect to be taxed as an S corporation?
   Yes. LLCs can elect S corporation tax status by filing IRS Form 2553, allowing members to reduce self-employment taxes while maintaining flexibility in management.
3. Are there income limits for S corp eligibility?
   No specific income limits exist, but S corporations cannot have more than 100 shareholders and must meet IRS ownership requirements.
4. Do S corporations pay federal income tax?
   No. S corporations generally don’t pay federal corporate income tax; profits pass through to shareholders, who report them on their personal returns.
5. Is an S corp better than an LLC?
   It depends on your goals. S corporations offer tax-saving potential and structured operations, while LLCs offer greater flexibility and fewer formalities.

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