Pros and Cons of an S Corp: 12 Hidden Things to Know

Choosing the right legal structure for your business entity lays the foundation for how your business operates. It's arguably one of the most important decisions you can make as an entrepreneur. S Corporation (S Corp) is a popular choice among small business owners, but what are the Pros and Cons of an S Corp?

Understanding the intricacies of the S Corporation business structure is crucial for making an informed decision. In this article, we will unpack the most important advantages and disadvantages of an S Corp so you can confidently lead your small business to success.

Key Takeaways

• An S Corporation is a tax classification that eligible small businesses can elect for potential business income and tax benefits.

• To start an S Corp, your small business must comply with certain eligibility requirements (not all businesses are eligible).

• There are certain tax benefits to an S Corporation status, but there are also important disadvantages of an S Corp that entrepreneurs should be aware of.

What Is an S Corp?

An S Corporation, or an S Corp, is a tax classification that combines the limited liability protection of a corporation with the pass-through taxation benefits of a partnership or sole proprietorship. Contrary to popular belief, S Corporation is not a legal business structure. It's a tax election that qualifying small businesses can choose to potentially enjoy certain tax benefits.

For some small businesses, S Corporation status allows them to avoid double taxation by passing profits, losses, deductions, and credits through to their owners, known as shareholders. The shareholders then report their business income on their personal tax returns. S Corporations are popular among small businesses and entrepreneurs.

S-Corp Requirements

Not all small businesses qualify for an S Corporation status. To qualify as an S Corporation, the business must meet certain eligibility criteria set forth by the IRS.

Eligible Business Structure

Only certain business entities are eligible to elect S Corporation status, including domestic corporations with no more than 100 shareholders. Partnerships and foreign corporations are not eligible for S Corporation status.

Shareholder Eligibility

Shareholders of an S Corporation must be individuals, estates, certain trusts, or tax-exempt organizations. Non-resident aliens, corporations, and partnerships are ineligible to be shareholders. If you're an individual, you must be a US citizen or resident to be a S Corporation shareholder.

One Class of Stock

S Corporations are limited to only one class of stock, which means all shareholders must have the same rights and preferences regarding distributions and liquidation proceeds.

Tax Year and Accounting Method

S Corporations generally must adopt a calendar year as their tax year unless they can establish a business purpose for using a fiscal year. Additionally, S Corporations are generally required to use the accrual method of accounting for tax purposes.

Consent of Shareholders

The election to become an S Corporation requires the unanimous consent of all shareholders. Each shareholder must sign and submit Form 2553 to the Internal Revenue Service (IRS) within the prescribed time frame.

6 Advantages of an S Corp

If your small business qualifies for an S Corporation tax status, there are potential tax advantages associated with it. Here are the main advantages of an S Corporation election for small businesses and entrepreneurs.

1. Pass-Through Taxation

One of the most significant advantages of an S Corporation is that it's a pass-through entity for tax purposes.

Unlike a C Corporation, where the entity itself is taxed separately from its owners, S Corporations pass profits, losses, deductions, and credits through to their shareholders, who report them on their personal tax returns. This avoids double taxation, making an S Corp status a great option for many small business owners.

2. Personal Liability Protection

Like other corporate structures, S Corporations offer limited liability protection to their shareholders. This means that the owner's personal assets are typically shielded from the debts and liabilities of the corporation. However, it's important to note that asset protection may not apply in cases of personal guarantees or instances of fraud or negligence.

3. Ability to Split Income

S Corporations allow owners to split income between salary and dividends, potentially reducing the overall tax burden. While owners must pay themselves a reasonable salary subject to payroll taxes, they can distribute additional profits as dividends, which can potentially be taxed at a lower rate than ordinary income.

4. Ease of Transferability

Shares of an S Corporation can be easily transferred or sold to new owners, which makes it a flexible ownership structure. This can be a great advantage for businesses looking to attract investors or transition ownership over time.

5. Credibility and Perpetual Existence

Operating as an S Corporation can enhance the credibility of a business in the eyes of customers, vendors, and potential partners.

Moreover, unlike sole proprietorships and partnerships, S Corporations have perpetual existence, meaning that changes in ownership or the death of shareholders do not affect the entity's legal standing.

6. Deductible Fringe Benefits

S Corporations can offer their employees and shareholders certain fringe benefits, such as health and life insurance, retirement plans, and educational assistance, which are deductible as business expenses, providing additional tax advantages.

There are over 10+ small business tax deductions that you may not be taking advantage of. Read this fail-proof small business tax write-off checklist!

6 Disadvantages of an S Corp

While there are known S Corporation advantages, S Corp status also comes with significant disadvantages that are not always obvious.

1. Restrictions in Ownership and Structure

S Corporations are subject to strict eligibility requirements, including limitations on the number and type of shareholders, who must be U.S. citizens or residents. Moreover, S Corporations can have only one class of stock, which limits the flexibility in structuring ownership and attracting investors.

2. Potential Taxation of Built-In Gains

S Corporations that were previously C Corporations may be subject to built-in gains tax if they sell appreciated assets within a certain time frame after electing S Corporation status. This tax can erode potential tax savings and complicate long-term strategic decisions.

3. Payroll Tax Obligations

While S Corporation shareholders can minimize their tax liability by taking distributions instead of salary, they must pay themselves a reasonable salary subject to payroll taxes. The payroll taxes include Social Security and Medicare contributions. Failing to do so can attract scrutiny from tax authorities and potentially lead to penalties for your small business corporation.

4. Limited Growth Potential

S Corporations may face limitations when raising capital through the issuance of different classes of stock or attracting venture capital funding. This is because S Corporations can't have more than 100 shareholders and are restricted from having corporate shareholders or non-U.S. residents.

5. Complex Compliance Requirements

This is perhaps one of the most important cons of an S Corp for entrepreneurs. S Corporations are required to adhere to various compliance obligations, including maintaining corporate records, holding regular shareholder meetings, and filing annual reports with state and federal authorities. Failure to meet these requirements can result in penalties or loss of S Corporation status.

As an entrepreneur, it can be hard to find the time to comply with these requirements and easy to make costly mistakes. For best results, always consult with a legal professional.

6. Potential for Disagreements Among Shareholders

If your S Corporation has multiple shareholders, conflicts and disagreements over business decisions, profit distributions, or management responsibilities can come up. This can lead to strained relationships and operational disruptions.

Should I Start an S Corp?

Deciding whether to elect for an S Corporation tax status is an important business decision. While an S Corporation offers enticing benefits such as pass-through taxation, limited liability protection, and operational flexibility, it also comes with its share of drawbacks. Eligibility restrictions, compliance obligations, and potential tax complexities can make S Corporation election challenging.

Ultimately, the S Corporation election is a deeply personal choice for every entrepreneur. Before making your decision, it's important to assess your specific business needs, long-term goals, and potential risks or complications. Consulting with legal and tax professionals can help you weigh the pros and cons of an S Corp.

Frequently Asked Questions

What are the main cons of an S Corp?

The main cons of an S Corp are ownership restrictions and complex compliance requirements. An S Corporation is restricted to no more than 100 shareholders, all of whom must be individuals (US citizens or permanent residents), estates, or certain trusts. Moreover, as a busy entrepreneur, it can be difficult to figure out how to comply with obligations like maintaining corporate records.

What are the advantages of an S Corp?

Pass-through taxation, the ability to split income between salary and dividends, and potentially saving money on self-employment tax are some of the main pros of an S Corporation. With pass-through taxation, profits and losses are passed directly to shareholders, avoiding double taxation at the corporate and individual levels.

Is it better to be an S Corp or LLC?

It depends on your specific business needs and circumstances. An S Corporation structure may potentially help you save money on self employment tax. An S Corporation also has an unlimited lifespan and heightened credibility. However, an LLC offers a more flexible management, fewer formalities, and no ownership requirements. Learn more about forming an LLC vs. S-Corp.

Do you pay less taxes with an S Corporation?

The short answer is that it depends. There are several ways to pay less taxes with an S Corporation, including pass-through taxation and splitting your business income between salary and dividends to reduce self employment tax liability. However, it ultimately depends on your individual circumstances and not all businesses pay less taxes with an S Corporation.

How does an S Corporation avoid double taxation?

An S Corporation is a pass-through entity for tax purposes, which means that S Corps pass their profits and losses directly to shareholders (owners). Shareholders report their business profits and losses on their personal tax returns, which means that they pay taxes only once, at their individual income tax rates.

Pros and Cons of an S Corp: Final Thoughts

Electing an S Corporation tax status offers several advantages to small business owners, but there are also certain disadvantages that entrepreneurs need to be aware of.

Pass-through taxation, ability to split income between salary and dividends, and deductible fringe benefits are great S Corporation pros. That said, restrictions and eligibility requirements along with convoluted compliance obligations can make it hard to run a S Corp. Consult with a tax professional to figure out the best course of action for your small business.