Making the right decisions for your business can be challenging. One thing you may wonder about is the benefits of your business becoming an S corporation. So, whether you are just starting up or established and expanding, we’ll cover the advantages and disadvantages of S corporations to help you figure out what path is best for your business.
What is an S Corporation?
An S corporation is a corporation that is treated as a pass-through entity through an election made with the Internal Revenue Service (IRS). It issues stock and is regulated like a company, with directors, officers, and shareholders. To create an s corp, Articles of Incorporation must be filed with the Secretary of State or similar government body—its name is derived from the fact that they are taxed under Subchapter S of the Internal Revenue Code.
Advantages of being an S Corp
The benefits of an S corporation often outweigh any perceived drawbacks. When it comes to transferring ownership or closing a business, the S corporation structure can be particularly advantageous. Sole proprietorships and general partnerships are usually excluded from these benefits. The following are some of the benefits of a S corporation:
- Pass-through taxation. At the corporate level, a S corporation does not pay federal taxes. Any profit or loss made by the company is “passed through” to the shareholders, who report it on their personal tax returns—avoiding double taxation (being taxed at both the corporate and individual level). This means that business losses can be used to offset other income on the tax returns of shareholders to decrease the amount of income tax owed. This can be particularly beneficial during the early stages of a new company’s development. (If a corporation does not elect S corporation status and earns passive income, it may be classified as a personal holding company).
- Limited Liability. S corp owners receive limited liability protection. Forming an S corp legally separates the business and its owners. As a result, shareholders aren’t personally responsible for business debts or liabilities so personal assets of shareholders, such as personal bank accounts, cannot be seized to satisfy company debts. In a sole proprietorship or general partnership, owners and the business are legally considered the same—leaving personal assets vulnerable.
- Straightforward transfer of ownership. An S corporation’s shares can be freely transferred without incurring tax effects. (In a partnership or LLC, the transfer of more than a 50% interest will result in the entity’s termination.) When an ownership interest is transferred, the S company does not need to make any changes to the property basis or follow any complex accounting rules.
- Heightened credibility. Because the owners have made a formal commitment to their business, operating as a S corporation may help a new business develop credibility with potential customers, employees, suppliers, and partners.
Disadvantages of being an S Corp
Keep in mind that some advantages can function as disadvantages for certain types of businesses and business plans. Here are some of the challenges of being an S corp.
- Strict qualification criteria. To be eligible to make a S corporation election — and to remain a S corporation — the company must meet strict requirements for the number and type of shareholders, as well as the types of shares it can issue. The federal tax code, not state corporation law, dictates these laws. These laws are, in a nutshell, as follows:
- Shareholders are limited to only individuals, estates and trusts, and certain tax-exempt institutions.
- There can’t be more than 100 shares in the company (although some family members can be counted as a single shareholder)
- There can only be one stock class (although differences in voting rights are permitted)
- Formation and other expenses. To keep its S corporation status, your company must follow a set of rules. You must first incorporate the company by filing Articles of Incorporation with the state of incorporation of your choice, appoint a registered agent, and pay the required fees. Many states also charge recurring fees like annual report and/or franchise tax fees. They are generally not expensive and can be deducted as a cost of doing business, however, these are costs that a sole proprietor or general partnership would not incur.
- Not recognized in every state. Louisiana is one of the states that does not recognize federal S business elections. Places where s corporations are not recognized may levy state taxes and fees as if you were a traditional corporation. Even though Texas acknowledges S corporations, they are still subject to the corporate franchise tax. Because the law is complicated and varies greatly depending on where you live, you should familiarize yourself with the laws in your state.