Knowing S corporations' advantages and disadvantages can help you decide if this is the right structure for your business. Pros of S corporations include potential tax savings, while cons include limitations on investment opportunities.

An S corporation is a corporation that's chosen a special tax status with the IRS. Like a C corporation, S corporations do the following:

  • Issue stock
  • Have a board of directors, officers, and shareholders

Unlike a C corporation, S corporations aren't taxed twice.

S corporations are similar to partnerships and sole proprietorships in that they pass most of the business income and losses to company shareholders.

The process for forming an S corporation is the same for forming a traditional corporation, which includes the following:

When you file to incorporate your business, it's automatically classified as a C corporation, or standard corporation. You must file for Subchapter S to obtain S corporation status. Your business must also meet several standards in order to be approved for this election.

Advantages

S corporation shareholders have limited liability protection, and there are no state residency requirements for S corporations. These businesses enjoy a good amount of privacy protection, particularly in states like Wyoming and Nevada.

An S corporations' pass-through taxation means that profits go to the shareholders, who then pay taxes on them at the individual level. The S corporation structure is beneficial for businesses that:&

  • Provide a service, such as consultants
  • Don't need large, costly equipment purchases before operations can begin
  • Don't have significant startup costs
  • Don't require a great deal of capital investment to make a profit

S corporations can attract investors by selling shares of stock in the company. You can freely transfer interest in an S corporation without worrying about negative tax consequences.

Because shareholders are not personally responsible for business debts, creditors can't go after a shareholder's personal assets — such as homes or personal bank accounts — to pay company debts.

An S corporation's shareholders can also be employees of the company and earn salaries. They're also able to receive dividends and other tax-free distributions from the corporation.

For new businesses, operating as an S corporation can quickly establish credibility with partners, vendors, investors, and potential customers, since they'll see the formal commitment owners have made to their company.

If an owner dies or leaves an S corporation, the business continues because it has perpetual existence.

Disadvantages

In court proceedings, S corporation shares are subject to sale and seizure at the shareholder level. Shareholders in a high-income tax bracket will pay more taxes on their distributions since they're taxed at the individual level.

Your business must meet certain requirements in order to be structured as an S corporation. If your business fails to meet the requirements, the IRS can revoke its tax status and charge back taxes for several years. You'll also have to wait five years before you can make the election again.

Your S corporation must adopt a certain tax year as outlined by the IRS. If you want a different fiscal year, you'll have to show a specific business purpose for it.

S corporations can only issue one class of stock, although voting and non-voting shares are allowed. The restriction on the amount of stock an S corporation can issue also means the business can't easily allocate income or losses to specific shareholders.

An S corporation can have no more than 100 shareholders, and none can be foreign individuals or foreign entities.

The IRS carefully scrutinizes S corporation payments because business income can be either listed as salary or dividends for shareholder-employees. You must pay owner-employees a reasonable salary. If the IRS identifies any issues with this, they may characterize wages as dividends. As a result, the company loses a deduction for paid compensation.

Every business type has its own pros and cons. S corporations are generally preferred by small business owners who have no plans for international expansion. In fact, the IRS created this structure specifically to encourage the creation of small businesses. Knowing the advantages and disadvantages will help you determine if this is the right structure for your company.

If you need help learning more about S corporations or other business types, 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, Stripe, and Twilio.