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S corporation is a term that comes up whenever a small business owner seeks advice regarding how to structure the business. Many people have strong views on which is better—an S corporation or an LLC. The fact is that there is not a single perfect choice. The best choice depends on many factors, including the type of business, the plans for the business and the short- and long-term goals of the owners. This article will help you understand the advantages and disadvantages of an S corporation, which is an important first step in determining if the S corporation is the right option for your company.
The first thing to remember is that an S corporation is simply a for-profit corporation that elected to be taxed under Subchapter S of the Internal Revenue Code, making it a “pass-through” entity for tax purposes. It is incorporated under and governed by the same state corporation laws as a corporation that was not eligible for S corporation tax status or whose shareholders chose not to elect that status. Therefore, an S corporation has the same non-tax advantages as a regular corporation. (A regular corporation is also referred to as a C corporation when discussing its tax status because it is taxed under Subchapter C of the Internal Revenue Code).
Four Advantages an S Corporation Can OfferWhile conventional wisdom views the following as advantages that an S corp offers its owners, it is important to realize that what is generally an advantage could be a disadvantage in some cases. For example, pass-through taxation generally is positive, but if you want to accumulate money for expansion—perhaps to build a new facility—a regular corporation could be the better choice because income can be retained within the corporation.
Asset Protection. All corporations, regardless of their tax status, provide the owners limited liability protection. This means that the owners’ personal assets are shielded from the claims of business creditors—whether the claims arise from contracts or litigation. LLCs provide limited liability protection as well.
Pass-through Taxation. An S corp is a pass-through entity for federal (and most state) income tax purposes. Business income, as well as many tax deductions, credits, and losses, are passed through to the owners, rather than being taxed at the corporate level. This avoids any chance of “double taxation,” which comes into play when dividend income is taxed at both the corporate level and at the shareholder level. A corporation taxed as a C corporation pays income taxes and therefore is subject to “double taxation”. An LLC is also a pass-through tax entity. However, it can elect to be taxed like a C corporation if that is in its best interests.
Salary and Dividend Payments. An S corporation owner can opt to receive both a salary and dividend payments from the corporation. This can result in an overall lower tax bill. Why? Because dividends are not subject to self-employment tax. Further, the corporation can deduct the cost of the wages paid when computing the amount of income that is passed through to the shareholders. However, the division between salary and dividends must be “reasonable” as determined by the IRS. (The IRS watches these types of transactions very closely and will step in and re-characterize the income if it feels the payments were unreasonable).
Ease of Conversion. Because the only difference between an S corporation and a C corporation is how it is taxed if the shareholders want to be taxed as a C corporation they only have to make a filing with the IRS. An LLC that is taxed as a pass-through but wants to be taxed as a C corporation also merely has to make a filing with the IRS. However, if the LLC owners want to convert their LLC into a corporation instead, they will have to comply with both their state corporation and LLC laws and file documents with the state.
Three Disadvantages of an S CorporationAs noted earlier, some advantages can function as disadvantages for certain businesses and business plans. Here are some of the “dark side” of the advantages, as well as some that are inherent in operating as a corporation, rather than the more flexible LLC.
Strict Qualification Requirements. In order to be eligible to make an S corporation election—and to continue to be an S corporation—the corporation must meet strict requirements on number and type of shareholders and types of shares. These rules are imposed by federal tax law, and not state corporation law. Briefly stated, these rules include:
• Only individuals, certain estates and trusts, and certain tax-exempt organizations can be shareholders
• There cannot be more than 100 shareholders (although some family members can be counted as a single shareholder)
• There can only be one class of stock (although differences in voting rights are permitted)
An LLC can be a pass-through entity without being subject to those restrictions. And although both an S corporation and an LLC are pass-through entities they are taxed under different sections of the Internal Revenue Code so their taxation is not identical.
Rigid Profit and Loss Allocation. Because it is a corporation, an S corporation is required to allocate profits and losses among the owners based strictly on the percentage of ownership or number of shares held. In contrast, an LLC is able to allocate its profits and losses in whatever proportions the owners desire. Thus, the founding owner who transfers 50 percent of the ownership to a new member could receive a disproportionate share of the income from the LLC. In an S corporation, the founders' allocation is reduced from 100 percent to 50 percent.
Corporate Formalities. At the risk of being redundant, it must again be stated that an S corporation is first and foremost a corporation. That means that it must observe all the corporate formalities imposed by its home state’s corporation statute. In contrast, the state LLC laws impose far fewer statutory formalities. Both corporations and LLCs also have to register to do business in states outside of the home state.
ConclusionS corporations can be the best choice if you are looking for a company structure that provides the advantages of a corporation along with pass-through taxation. However, there are requirements that must be met in order to make the election and must continue to be met for the election to remain valid. The advantages of being a corporation must be balanced against the lack of flexibility and the more extensive formalities imposed on a corporation versus an LLC.
This article was updated April 2018. It originally published February 2016.
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