Advantages and Disadvantages of Running Your Business as an S Corporation

Is the S Corporation Structure Right for Your New Venture?

When deciding on the right legal structure for your new business, many small business owners choose to form a corporation or limited liability company (LLC) and then elect to be taxed as an S corporation. This tax designation, often referred to as an “S corp,” offers several attractive benefits, such as pass-through taxation and potential savings on self-employment taxes. However, it’s equally important to weigh the possible disadvantages before settling on this tax classification for your venture.

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  What Is an S Corporation?

  An S corporation is a tax classification election available to eligible LLCs and corporations. An S corporation combines liability protection of a traditional corporation with the tax advantages of pass-through taxation. In this structure, profits, losses, deductions, and credits are allocated directly to shareholders, who then report these amounts on their individual tax returns. This approach generally eliminates the double taxation that can occur in standard corporations, as S corp income is taxed only at the shareholder level.

   

  Key Advantages of S Corporations

  • ● Limited Liability: As a shareholder, your personal assets are usually protected from business debts and claims. Unless you personally guarantee a loan or pledge assets, your exposure is limited to your original investment.
  • ● Pass-Through Taxation: S corporations don’t pay federal income tax at the corporate level. Instead, profits, losses, deductions, and credits flow directly to shareholders and are reported on their individual tax returns—a plus if your business incurs early losses.
  • ● Single Layer of Taxation: Most distributions provided to shareholders are taxed just once at the individual level, helping you avoid the double taxation faced by C corporations.
  • ● Potential Payroll Tax Savings: While salaries (even to owner-employees) are subject to FICA taxes, profits distributed beyond your salary usually are not—potentially yielding payroll tax savings compared to sole proprietorships, partnerships, or LLCs.
  • ● No Accumulated Earnings Tax: S corporations are not subject to the accumulated earnings tax imposed on C corporations and don’t risk being classified as personal holding companies.
  • ● Qualified Business Income (QBI) Deduction: Your share of S corporation income may qualify for the 20% QBI deduction, which could further reduce your tax bill.
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  Disadvantages of S Corporations

  • ● Shareholder Restrictions: S corps are limited to 100 shareholders, all of whom must be U.S. citizens or residents. Corporations, nonresident aliens, and most trusts and estates are generally not eligible to be shareholders, with some exceptions for certain trusts.
  • ● Limitations on Ownership Structure: An S corporation cannot own another S corporation (except for a 100% owned Qualified Subchapter S Subsidiary, or QSub), making expansion and complex ownership structures more challenging.
  • ● Single Class of Stock: S corps can issue only one class of stock, which restricts how profits and losses are allocated among shareholders and may limit fundraising options.
  • ● Basis Limitations: Shareholders cannot increase their basis in the corporation by personally guaranteeing corporate debt. This limits the amount of losses that can be passed through, making S corps less attractive for highly leveraged businesses such as real estate ventures.
  • ● Fringe Benefit Limitations: Shareholders owning more than 2% of the company are generally ineligible for many tax-free fringe benefits available to regular C corporation employees.
  • ● Calendar Year Requirement: S corporations typically must operate on a calendar year unless they meet specific IRS exceptions.
  • ● Built-In Gains Tax: If your S corporation was previously a C corporation, you may be subject to a special tax on built-in gains realized after the conversion.
  • ● Personal Tax Rates Apply: All S corporation income is taxed at your individual rates and does not qualify for the flat 21% corporate tax rate available to C corporations.

   

  Is an S Corporation Right for You?

   

  Each business has its own distinct needs, and the ideal structure will depend on your unique situation, goals, and growth plans. Carefully review the considerations above and speak with a qualified advisor to determine if an S corporation is the best fit for your business.

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  If you have questions or would like a personalized review, feel free to get in touch. Starting with well-informed choices can set your business up for lasting success.