S Corp: Advantages and Disadvantages for Small Business

Choosing the right business structure for your small business is one of the most important decisions you’ll make. There are many options, each with different taxes, paperwork, and levels of risk. For some, an S Corp may be the best structure.

What is an S Corporation (S Corp)?

An S Corporation is a business structure similar to a C Corporation in that they are both unique corporate entities, separate from their owners. With an S Corp, shareholders report business income, losses, deductions, and credits on their personal tax returns—taxed at their individual income tax rates—thereby avoiding double taxation on corporate income.

4 Advantages of an S Corp

1. Limited Liability Protection

Similar to a C Corporation, with an S Corp your liability is limited to the percentage of the company you own. Separating your personal assets from your professional assets can be beneficial in case your company is ever sued.

2. Pass-Through Taxation

With an S Corp, the business itself is not taxed. Instead, profits and losses are passed through to shareholders and paid at the individual level on their personal tax returns. Remaining profits can be distributed to shareholders as distributions, which are not subject to Social Security and Medicare taxes.

3. Stock Options

S Corps can sell shares of company stock, which can help raise capital. The procedure for issuing shares of stock is relatively simple. However, only one class of stock is available which may also discourage some investors.

4. Perpetual Existence

Like C Corps, S Corps can live on indefinitely. If a corporation owner were to pass away or leave, the corporation could continue to exist. This makes it easier to transfer stock or shares to individuals in the future or sell the S Corp altogether.

5 Disadvantages of an S Corp

1. Reasonable Compensation

Any shareholder who works for an S Corp must pay themselves “reasonable compensation.” The IRS deems reasonable compensation to be a fair market value—what a person with the skills needed for the position would be paid on the free market. If the IRS finds that shareholders are not paid reasonable compensation, they can reclassify any additional corporate earnings and wages, and in that case, you will have to pay Social Security and Medicare taxes. The IRS pays particular attention to owners of S Corporations who try and pay themselves a lower wage to avoid this tax.

2. Strict Guidelines

Profits and losses must be distributed to shareholders in proportion to their stake in the company. For example, if you own 25% of the company, you must receive 25% of the company’s profits or losses. Higher-income shareholders will pay more taxes on their distributions.

3. Professional Services Corporation Designation

Single owners of S Corps are seen as a Professional Services Corporation (PSC) by the IRS. All profits from a PSC are subject to SE (Self-Employment) tax. There is a large audit risk for PSCs.

4. Maintenance Cost

S Corps must file a number of state and federal documents and pay government fees to maintain their status. Because S Corps are created by individual states, there may be additional state taxes and regulations as well.

5. Ownership Restrictions

S Corps are limited to a maximum of 100 total shareholders.

The information provided in the MBO Blog does not constitute legal, tax or financial advice. It does not take into account your particular circumstances, objectives, legal and financial situation or needs.  Before acting on any information in the MBO Blog you should consider the appropriateness of the information for your situation in consultation with a professional advisor of your choosing.