Pros and Cons of an S-Corporation (S-Corp) for Small Business

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Among the multiple business structures the Limited Liability Company and the S-Corporation are two of the most popular, but is it worth it to elect for S-Corporation treatment for tax purposes?  Contrary to popular belief an S-Corp is not an entity that is set up like an LLC or Corporation, rather it is a tax designation that owners of LLCs or Corporations may elect.  Electing for your business to be treated as an S-Corp for tax purposes allows gains and losses of the business to flow through the corporate entity to the business owners who report the gains and losses on their individual tax returns.

Before your company can be designated as an S-Corp, however, you must ensure that it meets the four requirements of an S-Corporation. First, the corporation or LLC must be a domestic entity. Second, the corporation must be owned only by “allowable shareholders.” You may not elect your business for S-Corp treatment if it is owned by another corporation, a partnership, or nonresident aliens. Third, the corporation must not have more than 100 shareholders.  Fourth, there must be only one class of stock issued. After ensuring your business meets these requirements you may elect for S-Corp designation. 

Before deciding whether to elect for S-Corp treatment Consider the following pros and cons of an S-Corporation:

Pros:

  • S-Corps act as a Tax Flow-through – gains and losses incurred by the S-Corp are not taxed at the corporate level but instead flow through to the S-Corp’s owners who report the gains and losses on their individual tax returns.
  • Personal Asset Protection – Like other types of business organizations, S-Corps protect their owners from personal liability. This means that owners of the S-Corp will not be held personally liable for the business’s debts or judgments against the business despite the fact that an S-Corp is a flow-through tax entity. S-Corp owner’s personal assets will remain safe provided the S-Corp is operated as a separate entity (for tips on how to avoid piercing of the corporate veil click here).  However, liability protection is not 100% guaranteed.  Check out our blog post and video titled “4 Simple Steps to Protect Your Business from Piercing of the Corporate Veil” for more information on how to protect your personal assets from business creditors and liabilities. 
  • Characterization of Income from an S-Corp – The main benefit an S-Corp offers its owners is the ability of the owners to designate income from the S-Corp as salary or distributions.  Owners of an S-Corp may draw a salary from the S-Corp and distribute remaining profits to the owners. The portion of the income that is designated as salary will be subject to Social Security and Medicaid taxes, but the portion that has been designated as profit distribution avoids these extra taxes.  As long as the salary is reasonable and within proper parameters, S-Corp owners can save large amounts of money by avoiding Social Security and Medicaid taxes.
  • Out-of-Pocket Reimbursement – In situations where business expenses are not tax deductible, S-Corp owners may choose to be reimbursed for their business expenses (such as travel, business cellular plans, or office rental) by the S-Corp.  This may be accomplished by establishing an account payable plan by which out-of-pocket business expenses may be handled

Cons:

  • Recurring Expenses – S-corps require additional accounting work for payroll taxes which may result in additional fees to the owner.  However, the tax benefits often far exceed the additional costs. 
  • Limitations on Shareholders – As briefly mentioned above, an S-Corp may only be owned by individual shareholders or members (corporations, partnerships, and nonresident aliens may NOT be shareholders of an S-Corp).  Further, the S-Corp may have no more than 100 shareholders and may issue only one class of stock.
  • IRS Scrutiny – Because owners of the S-Corp can choose to designate part of their income derived from the S-Corp as either salary or dispersions, the IRS will more closely analyze your income designations to ensure that they align with reality and your salary is reasonable in light of the dispersion you collect.  Because of this it is important to make sure you sure you draw a reasonable salary (not questionably low).

Before deciding to elect for S-Corp designation for tax purposes be sure to consult with your tax and legal advisors to ensure you are making the correct decision.

If you are starting a new business and not sure where to start, check out our video and blog post entitled: 6 Key Steps to Starting a Business

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