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The S Corporation Advantages and Disadvantages

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The S Corporation Advantages and Disadvantages

What is an S Corporation?

An S Corporation is a corporation that is established through a special tax election available to corporations that meet certain criteria.

This tax election is made through the IRS. The S Corporation election allows a corporation to be treated as a pass through entity for federal tax purposes.

These means that the profits, losses, deductions, and credits of the corporation are passed through to the shareholders of the corporation when calculating federal income taxes.

For an S Corporation to be formed, IRS form 2553 must be filed within 75 days of the business’s incorporation.

 

What Should You Know About S Corporations?

In order to make a sub-chapter S election, the business must have fewer than 100 shareholders, but all of these shareholders must be individuals. Furthermore, an S Corporation can only issue one class of stock.

In addition, the S corporation must be owned by either a US citizen or a resident alien; this means that only legal residents of the United States can make a sub-chapter S election.

 

The Advantages of an S Corporation Election

Check out all the advantages of S corporations:

 

1. Liability Protection

Similar to a C Corporation, the personal assets of the owners of an S Corporation are protected for liability. This means that shareholders are not liable for the debts and liabilities that the corporation incurs and their personal assets cannot be seized to satisfy these debts and liabilities.

If a company fails to incorporate, however, the personal assets of the owners can be used to satisfy the debts and liabilities of the business due to the fact that the business is not a separate legal entity.

 

2. Avoid Double Taxation Issues

S Corporations avoid the issue of double taxation that befalls corporations by passing through
its profits and losses to shareholders in a manner similar to that of a sole proprietorship or
partnership.

C Corporations are taxed at both the corporation level and the shareholder level.

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S Corporations, on the other hand, are only taxed at the shareholder level. The shareholders
report the portion of the corporation’s income they receive on their personal income tax
returns and are taxed at their individual tax rates on this income.

If the business has recorded losses for the year, these losses can offset some of the other taxable income of the shareholders, lowering their tax rate.

 

3. Reduces Tax Obligations

Another advantage of incorporating as an S Corporation is that income can be characterized in a manner that reduces the tax obligations of the owners.

An S Corporation can characterize distributions of income as salary and dividends in a manner in which to maximize deductions related to business expenditures on the owners’ personal income tax returns so long as these characterizations are not completely illogical.

In addition, S Corporations only have to file their taxes once a year. A C Corporation, on the other hand, has to file its taxes quarterly.

 

The Disadvantages of an S Corporation Election

On the flip side, here are all the disadvantages of S corporations:

 

1. Restrictions on Stock

One disadvantage of the S Corporation is that there are restrictions placed on stock ownership.

The first restriction that an S Corporation faced is that it cannot have more than 100 shareholders. This may be suitable for small businesses, however, it limits a business’s ability to raise capital through the issuance of stock.

Furthermore, S Corporations can only issue on class of stock. This makes it more difficult to allocate profits and losses to specific groups of shareholders through their stock classification.

 

2. Adherence to All Corporate Formalities

In addition, S Corporations must adhere to all corporate formalities. This means that S Corporations are subject to the same incorporation expenses as C Corporations.

S Corporations can be subject to franchise taxes and other fees that are imposed on corporations in the state in which they are incorporated.

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3. More Inspection From IRS

S Corporations are often subjected to a higher level of scrutiny from the IRS.

S Corporations are permitted to classify their distributions to shareholders who are employed by the business as either salary or dividends in order for this income to get more favorable tax treatment.

Therefore the IRS has a tendency to look at these distributions more than distributions made by C Corporations.

 

4. Tough to Maintain Status

Furthermore, if they do not satisfy all of the filing requirements, S Corporations can actually loss their S Corporation status altogether. One of the most popular states to incorporate an S Corporation is Florida because you don’t have to pay State corporate income tax there.

 

Summary

Now that we’re at the end of the article, let’s recap on the pros and cons of S corporations.

The advantages:

  • Liability Protection
  • Avoid Double Taxation Issues
  • Reduces Tax Obligations

The disadvantages:

  • Restrictions on Stock
  • Adherence to All Corporate Formalities
  • More Inspection From IRS
  • Tough to Maintain Status

Do you have anything to add to this article? Leave a comment below.

Dan Western is the founder of Wealthy Gorilla. Dan has been running Wealthy Gorilla for the last 5 years, whilst traveling the world and being able to call Bali, Indonesia, his HQ. To this day, Wealthy Gorilla has become one of the fastest growing self-development sites in the world; with over 40 million views worldwide, and more than 200,000 followers on social media. Dan's mission is simply, to inspire others to live their dreams and be the person to whom they say; "Because of you, I never gave up."

1 Comment

1 Comment

  1. Evan

    Aug 18, 2016 at 10:00 am

    Hey Dan,

    Nice article here – did you know you can form an LLC and then elect to be taxed as an S corp?

    This helps save the headache of tons of paperwork, but also helps you avoid double / corporate taxation strategies! It’s the best of both worlds really. If you’re not going for an LLC, it’s probably good to build out the S Corp though depending on the size of your organization

    – Evan

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