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S Corporation Advantages and Disadvantages: The Complete Run-down

Business owners, especially new business owners, often struggle with making sense of the advantages and disadvantages of S corporation status.

Sure, you know that many businesses operate as S corporations, but you also sense that they can burden you and your accountant with extra work and expense.

Accordingly, in the paragraphs below, we explain and discuss the most significant "advantages and disadvantages of an S corporation" issues for small businesses:

Disadvantage #1: Extra Tax Accounting

S Corporations present their owners and managers with several disadvantages, but perhaps the biggest disadvantage for a previously un-incorporated business concerns the extra accounting required.

For the sole proprietorship that's considering an S corporation, the S corporation choice may require more or better bookkeeping and accounting. And this "extra accounting" disadvantage means that either you'll need to learn more accounting or you'll need to pay a bookkeeper or accountant to do it. You'll also, as a practical matter, need to buy a copy of an accounting software program like QuickBooks.

As compared to a sole proprietor, S corporation tax returns also cost more to prepare. Partly, the extra cost stems from the increased complexity of a corporate return. And partly, the extra cost stems from the fact that a corporate return is typically many more pages than a simple sole proprietorship tax return. An S corporation, for example, would often be required to prepare and submit balance sheets as part of its tax return.

Even if you've been able to prepare your own sole proprietorship tax returns by hand or by using something like TurboTax®, you may not want to prepare S corporation tax returns yourself. In our opinion, you shouldn't prepare a corporate tax return yourself. The corporate return is just too complicated for a non-accountant.

Finally, for one-person businesses, an S corporation may force the firm to do payroll. In other words, even if the proprietor is the only person working in the business, the business will need to make the owner an employee and begin paying the owner-employer a reasonable wage. Treating an owner as an owner-employee means the business needs to file additional quarterly and annual payroll tax returns.

If a business already employs workers, the extra headache of adding one more employee, the owner, usually isn't significant. But adding that first employee--even if the employee is the owner--creates a bunch of work.

Disadvantage #2: Extra Banking & Legal Costs

Unfortunately, a corporation may have extra banking and legal costs as compared to a sole proprietor.

Banks, for example, may charge more for checking accounts, loans, and other services. The S corporation may more frequently require the services of a good attorney to help with the legal aspects of starting and operating the entity (probably either a traditional corporation or a limited liability company) that elects Subchapter S status.

Finally, state governments, their agencies, and even other outside parties may require a business that's set up as a corporation to jump through additional legal or accounting hoops or to pay more in fees and taxes simply because of its corporate form.

Here are just three examples of these extra "hoops":

  • To get a contractor's business license in Arkansas, for example, a corporation must supply CPA-reviewed or CPA-audited financial statements, but a sole proprietor doesn't have to. Paying a certified public accountant for a financial statement review typically costs several thousand dollars and paying a CPA for an audit can easily cost ten or twenty thousand dollars.
  • A number of states make a corporation pay significant extra fees or taxes that a sole proprietor doesn't have to pay. California, for example, may require an annual franchise fee of several hundred or even several thousand dollars a year. Note that the California franchise fee runs a minimum of $800 a year and applies both to limited liability companies and to S corporations.
  • Massachusetts may levy an extra tax on S corporations once the corporation reaches a specified size.

Disadvantage #3: Ownership Restrictions

Another important disadvantage of an S corporation concerns an S corporation's ownership. An S corporation limits the type of shareholders allowed, the number of shareholders, and the type of ownership interest shareholders may have.

In an S corporation, for example, all the owners (shareholders) need to be U.S. citizens or permanent residents.

In addition, in an S corporation, the corporation's profits need to be allocated and distributions to shareholders need to be made purely on the basis of the ownership percentages. This means that an S corporation may have only one "class" of stock. You can't have preferred stock, for example. (Note: You can have nonvoting stock.)

Finally, in an S corporation, the number of owners is limited to 100 persons. Families, however, can often be counted as a single shareholder for purposes of the not-more-than-100-shareholders limit.

In comparison to a sole proprietorship, you should know that pretty much anyone can own or operate a sole proprietorship. In other words, you don't need to be a U.S. citizen or permanent resident to operate a sole proprietorship in the U.S. (Of course, resident and nonresident aliens do need to comply with immigration laws.)

And in comparison to a partnership, you should know that partnerships aren't limited to a specified number of partners or specified types of partners. Furthermore, a partnership can allocate profits and distribute money and property to its owners in almost whatever way it wants. (Note: A partnership profit-sharing formula can't be used merely to minimize taxes.)

Disadvantage #4: Extra Costs to Start and Stop

One final disadvantage needs to be considered by prospective S corporation business owners--the extra startup and termination costs.

Typically, sole proprietorships and partnerships are easier and less expensive to start than corporations. For example, a sole proprietorship or partnership can be started without anything more formal than a decision or a handshake.

In fact, people sometimes start sole proprietorships or partnerships without even realizing they've done so!

Furthermore, a sole proprietorship and partnership can almost always be started without any adverse tax consequence. And a partnership can almost always add partners without any tax cost.

In comparison, in order for a new or existing business to incorporate and then elect S status, the business needs to file articles of incorporation, articles of organization, or articles of formation with the state in order to start "existing" as a legal entity. A subchapter S election must then be filed with the Internal Revenue Service and in some cases with the state's tax agency.

Note: As described a bit later in this article, we do give away free, downloadable S corporation kits, which many people can use to set-up an S corporation on their own and without the help of an outside professional... More on this later on.

Furthermore, the requirements of Section 351 of the Internal Revenue Code need to be met so that the incorporation isn't viewed by the tax laws as the sole proprietor or partners exchanging the assets of the business for stock in a new corporation. In a nutshell, the Section 351 requirements boil down to the rule that the people incorporating a business must control at least 80% of the corporation's stock after the incorporation if they want to defer recognizing gain.

Note: A sole proprietor who incorporates his or her business and who thereafter remains the business' only shareholder should not have to worry about Section 351. But the logic of Section 351 should be kept in mind. If someone transacts business with a corporation in a way that creates profit to the shareholder, that profit can easily be taxed. If by incorporating, for example, a business owner foists off a bunch of debt or personal debt onto the new corporation, that liability relief may create tax liability.

A related disadvantage of an S corporation is that an S corporation often can't be liquidated without paying some federal and state income taxes. This problem of "taxes due at corporate termination" is a bigger worry with a regular, non-S corporation (called a C corporation, by the way.) But you can still find yourself paying taxes at the liquidation of an S corporation. And here's why: When a corporation liquidates, the corporation distributes property to its shareholders. If a particular item of property has a fair market value in excess of its depreciated cost, the difference between the fair market value and the depreciated cost gets recognized as either a gain or loss.

In comparison, with property in a sole proprietorship or partnership, merely winding up the proprietorship's or partnership's operation doesn't necessarily create gains or losses, even if the sole proprietorship or partnership distributes appreciated property to the owner or owners. (Note that converting business property or investment property to personal-use property may trigger tax.)

Advantage #1: Better Legal & Accounting Benefits

Subchapter S status also provides the shareholders and (maybe especially) shareholder-employees with three huge advantages. For example, S corporations do more than save their owners income and payroll taxes. S corporations also provide some general accounting and legal liability benefits.

As compared to a sole proprietorship or a general partnership, an S corporation should limit your business liability because to create an S corporation you'll first have to form a limited liability company or a corporation.

An S corporation, therefore, should reduce the risks the business' owners bear. The general rule is that a corporation's shareholders are not personally liable for the corporation's debts merely because of their ownership of the business. (Note that this same rule is also true of a limited liability company's owners, who are called "members".)

Another general advantage of an S corporation compared to a partnership (or an LLC that's treated as a partnership) is that the tax accounting should usually be easier for an S corporation than for a partnership.

Partnerships complicate tax accounting in ways that are beyond the scope of this short article. But just to give you an idea of the sorts of problems they create, a partnership in effect requires that another set of bookkeeping records be kept--records in addition to the regular books kept for tax accounting.

Let us also make this perhaps-obvious point: Some of the factors that we describe as disadvantages of an S corporation aren't really disadvantages once a business reaches a certain size or complexity.

For example, after a business's financial affairs get complicated, you'll always need good accounting even if it costs you more money. And after a business begins to pay significant income tax bills, you'll usually save money by using good accountants and attorneys, even if those professionals charge high fees. Finally, if you're already doing payroll for other employees, adding yourself as the owner to the payroll doesn't increase bookkeeping headaches much at all.

Accordingly, some of the factors that you might sort of consider as disadvantages of an S corporation are disadvantages only for very small S corporations-say S corporations with less than $50,000 in annual profits or S corporations with only a single owner-employee.

Advantage #2: Corporate Income Tax Savings

As compared to a regular C corporation, an S corporation saves corporate income taxes. How this savings occurs, though, is a little tricky. To explain:

If a regular corporation makes $100,000, the corporation pays corporate income taxes on that profit. If the leftover, after-tax profit is paid to shareholders as dividend, the shareholders pay a second, personal income tax on the dividend.

In the case discussed here, for example, the corporation might pay $20,000 of corporate income taxes on its $100,000 of profit (leaving $80,000 for dividends). And then the shareholder might pay another $12,000 of personal income taxes on its $80,000 of dividends.

In comparison, if an S corporation makes $100,000 in profit, the corporation pays no corporate income taxes on the profit. Rather, the profit is allocated to S corporation shareholders based on their ownership percentages. While the shareholders might pay around $25,000 in personal income taxes on their profit, they won't pay any income tax on the dividend (or what's actually called a "distribution" when its from an S corporation) when it's made.

In this simple example, the shareholders pay $25,000 of personal income taxes rather than $12,000 because of the S corporation. But the corporation doesn't have to pay the $20,000 of corporate income taxes.

An S corporation, therefore, means that the owners avoid a second, double tax. And avoiding the double tax means, of course, that as compared to a C corporation, an S corporation often saves business owners a substantial amount of income tax.

Note: You really have to work out with an accountant what the precise overall income tax savings are when comparing C corporations with S corporations. The savings amount depends greatly on the corporate and personal tax rates. Actual savings would probably be more if the corporate profits are very high and less if the corporate profits or shareholder incomes are very low.

Advantage #3: Payroll Tax Savings:

S corporations also offer another tax savings opportunity as compared to sole proprietorships, partnerships and C corporations that don't pay income taxes because owners extract all of the profit as salary: S corporations allow shareholder employees to save on payroll taxes.

We're going to be a bit general here, but payroll taxes basically include self-employment tax for sole proprietors and working partners in active trades or businesses and Social Security and Medicare taxes on shareholder-employees in corporations.

The payroll tax rate is, roughly speaking, 15% on the first $100,000 of sole proprietorship profit, partner's profit share, or shareholder salary and usually 3% on anything above the first $100,000.

This means that a business owner who makes $100,000 a year as a sole proprietor, partner, or shareholder-employee pays (either directly or indirectly) about $15,000 in payroll taxes.

And this means that someone who makes $200,000 a year as a sole proprietor, partner, or shareholder-employee pays (again either directly or indirectly) about $18,000 in payroll taxes: $15,000 on the first $100,000 of income and $3,000 on the second $100,000 of income.

For an S corporation shareholder-employee, however, payroll taxes are only levied on the portion of the profit that the corporation labels "salary." The corporation has to be reasonable in what it labels "salary," but if $50,000 is a reasonable salary, then only the $50,000 is subject to payroll taxes. At a 15% tax rate, that means the S corporation shareholder pays roughly $7,500 in payroll taxes.

As compared to a sole proprietor, partner or C corporation employee making $100,000, therefore, the S corporation saves its owner $7,500 a year. As compared to a sole proprietor, partner or C corporation employee making $200,000, the S corporation saves its owner $10,500 a year.

And, by the way, note that these amounts are savings per shareholder. If the example S corporation employs four shareholder-employees, the annual savings are roughly four times as much.

Three Clarifications:

A handful of confessions: First, we've been rough in our calculations and estimates. For example, the tax rate isn't really 15% on the first $100,000, it's really 15.3% on the first $113,600 in 2013 and probably 15.3% of some higher figure in years after that because of inflation.

Second, the tax rate on the earned income in excess of the 15.3% tax bracket isn't taxed at 3% but actually rather at 2.9% or 3.8%. The 3.8% rate kicks in if you make more than $200,000 if you're single, or more than $250,000 if you're married and file a joint return.

Third, finally, the payroll tax bill isn't quite as bad as we state here because half of the payroll tax bill is an income tax deduction.

These factors don't change the general payroll tax advantage of an S corporation, however: An S corporation can often save business owners substantial amounts of payroll tax if the business profit greatly exceeds what the business needs to pay owners for their work.

Interested in a Do-it-yourself S Corporation Kit?

If what you've read here about the advantages and disadvantages of an S corporation makes you think the option sounds interesting, you ought to download one of our do-it-yourself S corporation kits. The kits provide a bit more information about the S corporation option. And the kits provide the step-by-step instructions, forms, and formation documents you'll need if you do form an S corporation.

A couple of tips: First, to download the right kit for your state, find the state in the list that appears along the left edge of this page, click that link and then follow that page's instructions. Second, if you decide that an S corporation requires too much work, you may instead want to form a limited liability company-and so you should know that we also give away publish LLC formation kits from another, related website, www.llcsexplained.com.

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