What Are the Pros and Cons of an S Corporation?

When you’re starting a business, there are a variety of entities you can choose and each has its own set of pros and cons. If you’re certain that a corporation meets your needs, however, you’re probably wondering whether to choose a C or S corporation.

At a glance, C and S corporations have a lot in common. The owners of either are called shareholders, directors are elected to oversee business operations, and profits are distributed as dividends to shareholders according to how much stock each shareholder owns.

The major differences between C and S corporations come down to the flexibility to raise capital and the ability to assume certain tax advantages. We’re not really comparing S or C corporations here, however, so let’s not get ahead of ourselves. We’ll just be evaluating the pros and cons of an S corporation for now.

Advantages of an S Corporation

For small businesses, the advantages of an S corporation can often outweigh their disadvantages. Business owners who are weighing an S corporation against another entity like a partnership or even a limited liability company may be surprised at what this type of business can provide.

The following are a few of these advantages:

  • Flow-Through Taxation: Dividends skip corporate taxation and are paid out directly to shareholders, where they get taxed on a personal level. C corporations, which do not have flow-through taxation, have their profits taxed once before distribution and again on the personal level of each shareholder.
  • Write-Off Losses: Shareholders of S corporations can write off losses on their investments on their personal tax returns. This means someone who invested a sum of money to become a shareholder of an S corporation can take the company’s losses, on a pro-rata basis, against their other personal income and reduce their overall tax liability.
  • Limited Liability: An S corporation shields its shareholders’ personal assets from the company’s creditors. As long as a shareholder has not made a personal guarantee or has personal liability for a business debt, the company’s creditors can’t go after any shareholder’s personal assets.
  • Simple Transfer of Ownership: Ownership interests can be purchased and sold without triggering certain tax consequences – even if the transfer is for a 50-percent interest or greater.
  • Easier Accounting Rules: S corporations can use the cash method of accounting if they don’t have inventory and/or have gross receipts of less than $5 million. The cash method is much simpler than the accrual method, which larger corporations must use.
  • No FICA Taxation for Shareholder-Employees: When an S corporation shareholder is also an employee, FICA taxes (Medicare and Social Security) aren’t applied to their pro-rata taxable income and expenses.

Disadvantages of an S Corporation

While the advantages an S corporation offers can be beneficial to smaller businesses, there are some considerable disadvantages for those that intend to grow much larger.

The following are a few of these disadvantages:

  • Limited number of Shareholders: S corporations can only have up to 100 shareholders, which may limit the company’s ability to raise capital in the future. C Corporations can have an unlimited number of shareholders, which can positively affect their ability to raise capital.
  • Salary Requirements: The IRS requires all S shareholder-employees and officers to earn a salary, even if the company is not yet profitable. This is to prevent companies from inappropriately avoiding the payroll tax by compensating a shareholder-employee with dividends. Salary requirements are really only a disadvantage when a company is struggling to make its payroll.
  • Shareholder Agreements May Limit Transfers: While it’s easier in principle to buy and sell stock in an S Corporation, because there may be a limited number of shareholders, terms of a shareholder agreement may provide limitations. A vote among the shareholders may be required to approve the transfer or a specific price per share may be set for one shareholder to buy out another. A poorly conceived shareholder agreement can thus place the company’s owners at an unintended disadvantage when it comes time to sell.
  • Greater IRS Scrutiny: Because an S corporation’s profits can be distributed to shareholders as salaries and/or dividends, the IRS will keep a close eye for irregularities that may appear as if the company is skipping payroll or other taxes. This means S corporations must be especially careful with their accounting and business practices because they may be at a much higher risk of an audit.
  • No Foreign Investment: All S corporations must be based in the U.S. and all shareholders must be U.S. citizens, legal residents, estates, and other such U.S.-based entities.

Are You Forming a New Company? We Can Help.

If you’re thinking about creating a new business, you know choosing the right type of business structure is no small decision. If you have considered establishing your new company as an S corporation, we hope you found the information above useful.

That said, we know that business formation can be a complicated process for any business owner to handle on their own. Duke Law Firm has more than 12 years of experience when it comes to helping new companies get off the ground, and we can provide the legal support you need right now.

If you require legal advice and services to help you create your new business, get in touch with us today. Call Duke Law Firm at (210) 880-0652 or contact us online to learn more about how we can assist you.