Choosing the right entity for your business is essential for tax considerations, liability, and growth potential. An S corporation may provide benefits, but there are also limitations. Here are some advantages and disadvantages of choosing the S Corp entity.
Ownership & Stock
An S Corp can have no more than 100 shareholders, and all must be U.S. citizens or residents. Additionally, only individuals, certain trusts, and estates can be shareholders (no corporations or partnerships). An S Corp can only issue one class of stock, limiting its ability to structure equity investments and attract venture capital.
Profits and Taxes
Once the S corporation starts earning profits, the income is taxed directly to you, whether or not it’s distributed. It will be reported on your individual tax return and combined with income from other sources. Your share of the S corporation’s income isn’t subject to self-employment tax, but your wages will be subject to Social Security taxes. If the income qualifies as qualified business income (QBI), you can take the 20% pass-through deduction, subject to various limitations.
Note: The QBI deduction is set to expire after 2025 unless extended by Congress. However, the deduction will likely be extended and maybe even made permanent under the Tax Cuts and Jobs Act extension being negotiated in Congress.
Shareholders who work in the business can receive a reasonable salary, and any remaining profits can be distributed as dividends, which are not subject to self-employment taxes (Social Security & Medicare). But beware, if the IRS determines salaries are too low to avoid payroll taxes, it may reclassify distributions as wages and impose penalties.
Unlike an LLC, where members can allocate profits and losses flexibly, an S Corp must distribute profits and losses strictly based on share ownership percentage.
Some states impose franchise taxes, entity-level taxes, or other fees on S Corps (e.g., California charges a 1.5% tax on net income for S Corps).
Debts
One major advantage of an S corporation over a partnership is that shareholders aren’t personally liable for corporate debts. To ensure this protection, it’s crucial to:
- Adequately finance the corporation,
- Maintain the corporation as a separate entity, and
- Follow state-required formalities (for example, by filing articles of incorporation, adopting bylaws, electing a board of directors and holding organizational meetings).
Other Pros and Cons of an S Corp:
- Shareholders who own more than 2% of the S Corp are treated like self-employed individuals for fringe benefit purposes. This means many benefits that are tax-free for regular employees are included in the shareholder’s taxable income.
- Compared to an LLC, transferring ownership in an S Corp is often simpler because shares can be transferred without triggering complicated legal and tax issues.
- Small S Corps (with gross receipts under $27 million as of 2024) can use the cash accounting method, simplifying bookkeeping and tax reporting.
- Corps must follow corporate formalities, such as holding annual meetings, keeping corporate minutes, and maintaining bylaws. These administrative requirements are stricter than those of an LLC.
If you are starting a new business or considering changing the entity-type of a current one, give us a call to help you choose which entity is best for your venture. We can help you analyze all facets to help with tax mitigation and your business goals.
