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Pros and Cons of Starting a Business as an S Corporation

An S Corporation which is referred to as Small Business Corporation is a business elected for S Corporation Status through the IRS. This business status allows the taxation of the company to be similar to a partnership or sole proprietor as opposed to paying taxes based on a corporate tax structure. Please note that S corporations are taxed under Subchapter S of the Internal Revenue Code (IRC).

As a corporation, an S corporation is created through filing Articles of Incorporation with the Secretary of State or similar government body. It issues stock and is governed as a corporation, with directors, officers, and shareholders who function in the same manner as their C corporation counterparts.

The owners (the shareholders) have the same protection from liability as shareholders of a C corporation. An S corporation shareholder’s personal asset, such as personal bank accounts, cannot be seized to satisfy business liabilities. Just like a sole proprietorship or even a partnership, an S corporation passes through most of its income and loss items to the shareholders.

Unlike a regular corporation, there is no “double taxation,” meaning that the owners do not need to pay taxes twice – once at the corporate level and again on the individual shareholder level. Each shareholder is subject to his or her own individual tax rate on the profits and losses passed through to him or her, recorded as net income on the income tax return.

Interestingly the pros of an S corporation often outweigh any perceived cons but irrespective of how attractive and easy to set up a business legal entity or structure is, there are always pros and cons of owning such business status hence the need to weigh your options before choosing one. In this article, we will be looking at the pros and cons of owning an S Corporation.

Pros of Owning an S corporation

1. There is No Corporate Tax for S Corporations

In S corporations, the profits and losses accrued to the business pass through to the corporation owner’s personal income tax. An S corporation does not pay federal taxes at the corporate level. This is similar to Limited Liability Company where the tax “pass-through” allows you to avoid “double taxation”.

This means that business losses can offset other income on the shareholders’ tax returns to reduce income tax paid. This can be extremely helpful in the startup phase of a new business. It is not like a non-corporate business structure, where even though you can avoid corporate taxes but you will still be expected to file a tax return every year.

2. Protects Assets of Its Shareholders

Another pro of owning an S corporation is that the business status protects the personal assets of its shareholders. As a matter of fact, aside an express personal guarantee, a shareholder does not have personal liability for the business debts and liabilities of the corporation.

This mean that creditors cannot pursue the personal assets (cars, house, bank accounts, etc.) of the shareholders of the company to pay business debts. In a sole proprietorship or general partnership, owners and the business are legally considered the same—leaving personal assets vulnerable.

3. Reduced Taxable Gains

People that own S corporation choose this business status simply because they want it to be part of their retirement strategy. In essence, selling an S corporation business can be part of your retirement strategy. And this is so because when an S corporation is sold, the owner will have reduced taxable gains.

4. Ability to Write off Start-up Losses

Another pro of owning an S Corporation is the ability of the owner to write off their startup loss without any consequence. As expected, most new businesses experience teething period at the initial stage of starting the business hence it is expected that they will have many expenses and losses.

With S Corporation, these losses can be offset against your personal income. As a matter of fact, a regular corporation would have the losses locked within the company and not applied to your income.

5. Shareholders Can Be Employees

S corporation shareholders can be employees of the business and draw salaries as employees. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation.

A reasonable characterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability, while still generating business-expense and wages-paid deductions for the corporation.

6. Ownership Can Easily Be Transferred

Another pros of S corporation that should not be ignored is the fact that ownership of the business can easily be transferred without triggering adverse tax consequences. (In a partnership or an LLC, the transfer of more than a 50-percent interest can trigger the termination of the entity.) The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.

7. Cash Method of Accounting

Corporations are mandated to make use of the accrual method of accounting unless they are considered to be small corporations. (A small corporation has gross receipts of $5 million or less.) S corporations, however, usually don’t have to use the accrual method unless they have inventory.

8. Ability to Grow Your Credibility

The fact that the owner of an S Corporation is always interfacing with customers, employees, vendors and partners gives the owner to prove to them that he or she can be trusted hence he can take advantage of this to grow his or her credibility. In business, credibility is a social capital that be converted to business capital if the owner of the business knows how to go about it.

Cons of Owning an S Corporation

Here are some of the cons of owning an S Corporation:

a. You Will Be Restricted to One Class of Stock

One of the obvious drawbacks of owning an S Corporation business is that you will restrict your company to issuing just one class of stock. The implication of that is that your inability not to be able to free issue different classes of stock affords a business less control over the company and limitations on the stock value.

b. Does Not Offer Complete Protection of the Business

Even though S corporations business status offer protection against liabilities, it is important to clearly state that liability protection is not a complete protection of any business. In essence, you can be personally liable for your actions as an individual. People are getting smarter which is why many lenders are now requiring personal guarantees especially when dealing with S Corporations.

c. Less Attractive to Outside Investors

Another key drawback of S Corporation is that the business status is less attractive to outside investors not just because the business is small, but because as expected, Venture capitalists will not want to see the pass-through tax setup or a limit of 75 shareholders. Expanding and growing your company require money which is why, if you will need venture capital, the regular corporation structure will be a better choice.

d. Attracts Closer Scrutiny from IRS

Due to the fact that the amounts distributed to a shareholder can be dividends or salary, the IRS scrutinizes payments to make sure the characterization conforms to reality. As a result, wages may be recharacterized as dividends, costing the corporation a deduction for compensation paid. Conversely, dividends may be recharacterized as wages, which subjects the corporation to employment tax liability.

e. Formation and Ongoing Expenses

As expected, in order to successfully operate as an S corporation, it is obligatory to first incorporate the business by filing Articles of Incorporation with your desired state of incorporation, obtain a registered agent for your company, and pay the appropriate fees.

Many states also impose ongoing fees, such as annual report and/or franchise tax fees. Although these fees usually are not expensive, and can be deducted as a cost of doing business, they are expenses that a sole proprietor or general partnership will not incur.

f. Less Flexibility When It Comes to Allocating Income and Loss.

Due to the nature of the one-class-of-stock restriction, an S corporation cannot easily allocate losses or income to specific shareholders. Allocation of income and loss is governed by stock ownership, unlike a partnership or LLC where the allocation can be set in the operating agreement.

Also, the necessary accumulated adjustment account can be cumbersome to maintain, requiring input from an accounting professional. (Please note that Shareholders of C corporations ordinarily can’t deduct any losses at all, unless their stock becomes worthless or is sold at a loss.)

g. Required S Corporation Meetings

With S corporation, your status will still be a corporation with the requirements of having regular meetings and maintaining company minutes but you have to take into consider the added time in operating an S Corporation.

Small businesses today are making the choice to form a Limited Liability Company (LLC) because they are easier to operate. Please note also that an S corporation must adopt a calendar year as its tax year unless it can establish a business purpose for having a fiscal year.

h. Fringe Benefits are Taxable

With S Corporation, most fringe benefits provided by the corporation are taxable as compensation to employee-shareholders who own more than 2 percent of the corporation.

Please note that with tax qualification obligations any mistakes regarding the various election, consent, notification, stock ownership and filing requirements can accidentally result in the termination of S corporation status. Although this is relatively rare, and usually can be remedied easily, it is still an issue that is not a factor with other business forms.