An S corporation is a small business corporation that has elected to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. This corporate structure provides certain tax advantages and disadvantages when compared to other corporate structures, such as C corporations and LLCs.
This article walks you through highlighted pros when forming an S corporation, including tax benefits and protections to business owners; and a few potential cons to consider as well, such as the requirement for a formal business structure and compliance with certain IRS rules. With careful planning, though, an S corporation can be a great choice for your business.
S corporation advantages: pass-through taxation, limited liability protection and credibility
No federal taxes at the corporate level
An S corporation is a special type of business entity that offers certain tax benefits. One of the key advantages of an S corp is that it doesn’t have to pay federal income taxes at the corporate level. Instead, the company’s shareholders pay taxes on their share of the company’s profits. This can save the company significant amounts of money in taxes each year.
Additionally, pass-through taxation is a key feature of S corporations. Being taxed as pass-through entities means the business itself is not subject to corporate income tax. The profits, losses, deductions and credits of the business are flowed through to the shareholders, who report them on their individual tax returns.
Lower self-employment tax (FICA payrolls withhold tax)
Self-employment tax is a social security and medicare tax primarily for individuals withheld from the pay of most wage earners.
According to the IRS, the self-employment tax rate (Social security and Medicare taxes) in the US is 15.3%, including 12.4% for social security (such as old-age, survivors, disability insurance) and 2.9% for medicare (hospital insurance).
You must pay self-employment tax if your net earnings from self-employment reached $400 or more, or if you owned a church income of at least $108.28.
One of S corp tax advantages is the ability to lower your self-employment tax burden. If you are the sole owner of a business, you would typically have to pay both income taxes and self-employment taxes on your business profits. However, with an S corporation, you can choose to only pay Social security and Medicare taxes on the salary you draw from the business, rather than on the business profits themselves (Such profits are only subject to the income tax).
High level of asset protection
S corporation can offer some liability protections for your personal assets. If your business is sued or incurs debts that it cannot pay, your personal assets will not be at risk if they are held in the S corporation. This can provide peace of mind and some financial security in case of legal or financial trouble for your business.
S corps have perpetual existence, meaning that they exist indefinitely. This is one of the advantages of S corp over a limited liability company, which dissolves upon the death of their members. If you want to create a business that will last beyond your lifetime, an S corp may be the best structure.
Flexible accounting methods
S corporations allow business owners to choose how to account for their income and expenses, which can provide them with enhanced flexibility. This flexibility allows s corporation shareholders to use the accounting method that results in the lowest taxable income. For example, S corporation shareholders who have inventory can elect to use the cash method of accounting, which does not require the recognition of inventory until it is sold.
Ease of ownership transfer
S corp shareholders can transfer their ownership interests much more easily than the owners of C corps or other business entities. Shareholders can transfer their shares to another corporation without having to go through a lengthy and expensive process.
One of the main advantages of setting up a business as an S corporation is the enhanced credibility. When you are an S corporation, it shows potential customers and clients that you are a serious and legitimate business. This can help you to win over new customers and clients, as well as keeping the ones that you already have.
Similarly, the ability to raise capital is one of S corp advantages that comes with this business structure. If you are looking to expand your business or to take it to the next level, then you will need to raise capital. When you are an S corporation, it is easier to attract investors and get loans from banks. This is because S corporations are seen as being more stable and less risky than other types of businesses.
S corporation disadvantages: complicated obligations and stock-related restrictions
More corporate formalities and tax obligations
One of the biggest S corporation’s disadvantages is that it is subject to more stringent regulations than other business entities. Evidentially, S corporations must file annualy Income tax return (Form 1120-S); if applicable the quarterly federal tax returns for employers (Form 941) and keep detailed records of their financial activities. Additionally, S corporations can only have a limited number of shareholders, which may limit their growth potential. You may want to consider compliance requirements as an S corporate here
Stock ownership restriction
S corporations are subject to certain restrictions on ownership, which may impact the decision of whether to form an S corporation.
- The number of shareholders is limited
S corporations can have no more than 100 shareholders, and all shareholders must be U.S. citizens or resident aliens. This can be a disadvantage if the business needs to raise capital by selling equity to investors.
- All shareholders must consent to the election of S corporation status
If even one shareholder does not agree to the S corporation election, the business will not be able to qualify for this corporate structure.
- S corporations are not allowed to have certain types of shareholders
Those shareholders are non-resident aliens, partnerships, corporations, or other S corporations. This limits the potential pool of shareholders that an S corporation can have.
Increased level of scrutiny from the IRS
S corporation is subject to more scrutiny from the IRS, especially on the balance of salary payments versus dividends. In an S corporation, the IRS is looking for a reasonable salary. If the shareholders of an S corporation are also employees, they must pay themselves a reasonable salary.
To sum up, S corporation has perpetual existence, limited liability protection, and pass-through taxation. Yet, choosing S corp status also has strict requirements, such as the number of shareholders, only one class of stock, and US citizenship. There are also limits on who can be a shareholder and other S corporation advantages and disadvantages that you may now be aware of.
Still uncertain whether S corporation is the right choice for your business in the United States? Give our tool a try and prepare a good business plan!
Feel free to chat with our consultants if you have more questions about US business structures or where to start your business in the US.
Disclaimer: While BBCIncorp strives to make the information on this website as timely and accurate as possible, the information itself is for reference purposes only. You should not substitute the information provided in this article for competent legal advice. Feel free to contact BBCIncorp’s customer services for advice on your specific cases.
- S corporation advantages: pass-through taxation, limited liability protection and credibility
- S corporation disadvantages: complicated obligations and stock-related restrictions
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