S Corporations: Learn 15 Advantages and Disadvantages

S Corporation Advantages

Is an S Corporation the right entity type for you?

This is a great question to explore when starting a business, or changing your existing business from a sole proprietor or general partnership, because it can make such a difference in taxes, the number of shareholders and asset protection. An S Corporation is one of the three popular choices for those incorporating their business. Other choices include Limited Liability Companies (LLCs) and C Corporations.

Business owners can select how they wish to be taxed, and an S Corporation is one of those tax designations that can make a big difference in how much you pay in taxes, how to handle profits and distribute shares. There are pros and cons to every entity type and it’s important to understand what is the best business model for you. Advantages and disadvantages are listed below.

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An S Corporation is a corporation that has elected to be taxed as a flow-though entity (similar to an LLC or Limited Partnership). The “S” also refers to an IRS code section. This type of taxation, the S election, allows the shareholders to be taxed only at the individual level instead of at both the corporate and individual level, thus avoiding the double taxation like the C Corporation. There is no federal income tax levied at the corporate level, unlike C Corporations which are taxed at both the corporate level and the individual level, thus earning the description “double taxation.” S Corps are favored by many business owners for their single taxation (as opposed to the double taxation of a C Corp) is limited liability protection – especially with a Nevada corporation with charging order protection extended to corporate shares – make the S Corp an attractive entity choice.

Please know that of all of the entities the S Corp has certain restrictions on ownership. There can only be 100 or fewer owners, which all must be individuals or their living trusts. Corporations, multi-member LLCs, and non-US residents cannot be S Corp owners. If the restrictions aren’t followed, the IRS will decide the corporation is C Corp and a double tax them accordingly.

Is Your Entity Structure the Right One for You?

If you are operating as a sole proprietor or general partnership, the simple answer is no. Those entity structures do not provide asset protection, and you could lose your personal possessions if your business is sued. The S Corporation still provides limited liability protection and is a good entity for many business situations.

Sometimes, the “S” Corporation is “Simply Better”

We at Corporate Direct suggest S Corporations for many service-oriented businesses to avoid being characterized as a Personal Service Corporation, or “PSC” by the IRS.

PSCs are C Corporations that are classified by the IRS as providing a service, such as consulting, to the general public. Now, as you may know, the IRS assesses C Corporations with a pretty low initial rate — 15% on earnings up to $50,000. That’s quite a bit lower than you would pay personally, if you were receiving that same $50,000 as salary. And, that 15% rate is also lower than you would pay if your business was an S Corporation. So, to head off the anticipated revenue drain, the IRS closed the loophole by designating C Corporations that provide services as PSCs. The tax rate for PSC earnings? 35%! That’s probably higher than you would pay through your S Corporation, if you took a reasonable salary and the rest as passive income. And, it’s enough, in many cases, to make the difference between going “S” or going “C.” Again, you will work with your CPA, tax and/or legal advisor to determine the best entity for your specific situation.

Corporate Direct can help you understand the restrictions and benefits of the S Corporation. To learn more simply call 1-800-600-1760 or request a free 15 minute consultation.

Advantages of S Corporations:

  • Limited liability for management and shareholders. (Learn more about limiting liability here.)
  • Unlimited number of management, no state residency requirements.
  • Distinct, court-recognized existence, which helps protect you from personal liability than can cause you to loose your personal wealth in assets like your home, car, or nest egg.
  • Flow-through taxation: Profits are distributed to the shareholders, who are taxed on profits at their personal level.
  • Good privacy protection, especially in Nevada and Wyoming. (Learn why privacy matters.)
  • Great income-splitting potential for owner/employees. Can take smaller salary and pay income taxes and regular payroll deductions, then take remainder of profit as a distribution subject to income tax only.
  • S Corporations are great for businesses that:
  • will provide a service (i.e. consultants);
  • will not have significant start-up costs;
  • will not need to make major equipment purchases before beginning operations; and
  • will make a sizable amount of money without a great deal of effort and expense.

Disadvantages of S Corporations:

  • At shareholder level, shares are subject to seizure and sale in court proceedings.
  • Maximum of 100 shareholders, all of whom must be U.S. residents or resident aliens. Shares must be held directly, except in special circumstances.
  • Owner/employees holding 2% or more of the company’s shares cannot received tax-free benefits.
  • Because flow-through taxes will be paid at the personal rate, high-income shareholders will pay more taxes on their distributions.
  • Not suitable for estate planning vehicle, as control is ultimately in the hands of the stockholders. In a planned gifting scenario, once majority control passes to children from parents, children can take full control of the company.
  • If tax status is compromised by either non-resident stockholder or stock being placed in corporate entity name, the IRS will revoke status, charge back-taxes for 3 years and impose a further 5-year waiting period to regain tax status.
  • Not suitable to hold appreciating investment. Capital gain on sale of assets will incur higher taxes than with other pass-through entities such as LLCs ad Limited Partnerships.
  • Limited to one class of stock only.

What is Needed to Form a Corporation? How Does it Protect Me?

Essentially, you file a document that creates an independent legal entity with a life of its own. It has its own name, business purpose, and tax identity with the IRS. As such, it — the corporation — is responsible for the activities of the business. In this way, the owners, or shareholders, are protected. The owners’ liability is limited to the monies they used to start the corporation, not all of their other personal assets. If an entity is to be sued it is the corporation, not the individuals behind this legal entity.

A corporation is organized by one or more shareholders. Depending upon each state’s law, it may allow one person to serve as all officers and directors. In certain states, to protect the owners’ privacy, nominee officers and directors may be utilized. A corporation’s first filing, the articles of incorporation, is signed by the incorporator. The incorporator may be any individual involved in the company, including frequently, the company’s attorney.

The articles of incorporation set out the company’s name, the initial board of directors, the authorized number of shares, and other major items. Because it is a matter of public record, specific, detailed, or confidential information about the corporation should not be included in the articles of incorporation. The corporation is governed by rules found in its bylaws. Its decisions are recorded in meeting minutes, which are kept in the corporate minute book.

Can I Change Entity Types?

Yes, if you think you may want to go public at some point in the future, but want initial losses to flow through, consider starting with an S Corporation or a Limited Liability Company. You can always convert to a C Corporation at a later date, after you have taken advantage of flowing through losses. Corporations can make the election at the beginning of its existence or at the beginning of a new tax year.

More Benefits to Business Owners: No Self-Employment Tax!

The big benefit of S corp taxation is that S corporation shareholders do not have to pay self-employment tax on their share of the business’s profits. But they will be taxed on the salary they pay themselves. This is the catch. Before there can be any profits, each owner who also works as an employee must be paid a “reasonable” amount of compensation (e.g., salary) that is subject to Social Security and Medicare taxes to be paid half by the employee and half by the corporation. As such, the savings from paying no self-employment tax on the profits only kick in once the S-corp is earning enough that there are still profits to be paid out after paying the mandatory “reasonable compensation.”

Contact our Incorporation Experts

Do you need advice on the best entity for your business?  Are you ready to set up your own S Corporation, but have some lingering questions? Call Corporate Direct toll-free at 1-800-600-1760, or sign up for a free 15-minute consultation with our incorporation experts.

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