Filing as an S corp is one of several options that you have when starting a new business opportunity. There is a misconception that being an S corporation is both expensive and time consuming. It’s an entity that is treated as a pass-through entity, so it must file articles of incorporation at the state level and will issue stock. As with any corporation, the profit or loss is passed on through the shareholders through changing stock prices. In return, no personal assets to shareholders or business owners are at risk to satisfy the liabilities the S corporation may have.
There are other S corp pros and cons to consider when structuring a new business as well, so here are a few of the key points to review.
What Are the Advantages of an S Corp?
1. It is easier to secure capital financing through investor support.
Creditors cannot pursue shareholders for any business liabilities that may exist. This includes bank accounts, personal assets, and any other item that has value. General partnerships and sole proprietorships do not have this same legal protection, giving investors a better opportunity to see their money grow with the S corp. This makes it safer for investments to be made, allowing the business to secure their capital financing.
2. Pass-through status has certain tax benefits.
The S corporation does not pay any taxes at the federal level. This is also true for a majority of states when it comes to local tax rules. This means the shareholders report profits or losses on their personal income tax returns instead, potentially allowing one S corp loss to offset other income to limit tax liabilities. This helps the S corporation be able to stay in business in those leaner early years.
3. Shareholders can also draw a salary as an employee.
S corporations are allowed to have employees become shareholders of the business while still drawing a salary. They are also allowed to receive dividends from their shares and receive other tax-free distributions that are related to their shareholder status. This also helps out the owner of the business because those salaries, dividends, and distributions are business expenses that can offset their own personal profits.
4. Ownership is a straightforward process.
In an LLC or a general partnership, a sale of more than 50% of the interest in the business can trigger its termination. In an S corporation, all interests can be transferred freely without any difficult tax issues being created. This is because there is no adjustments necessary to the property basis or equity percentages that must be recalculated.
5. It’s an easy way to gain credibility outside of a personal financial situation.
Because business and personal interests are kept separate in the S corp, this means a person’s credit score is not reflected in the credit viability of the business. Someone may have a 620 credit score from a foreclosure, yet be able to have a highly successful and credit worthy business thanks to the structure of the S corporation rules. This allows the ownership to establish an independent reputation for their business outside of their personal reputation.
6. The business has an independent life.
Because the credit and income profiles are separate from shareholders, the S corporation has an independent life of its own. This means shareholders can come and go and the business will continue to exist. Even if the primary shareholder in the S corporation passes away, the business does not terminate. The process of doing business remains relatively consistent.
What Are the Disadvantages of an S Corp?
1. There are numerous initial and ongoing expenses that must be considered.
The fees for filing the initial articles of incorporation and obtaining the initial business licenses are generally over $1,000. Many states impose annual or 2-year fees on S corporations as well. There may be a need to obtain a registered agent. Franchise tax fees, business and occupation taxes, and other costs are also present in various forms that other business structures are not required to pay. They can, however, be written off as business expenses.
2. One mistake can terminate S corporation status.
There are numerous rules in place that must be consistently followed to maintain this business structure. This includes certain filing requirements, reporting requirements, stock ownership rules, board of directors elections, and the publication of certain meeting notes. A failure to do so, though rare, can result in the termination of this business status and must be part of the consideration process.
3. Only one classification of stock is allowed.
Although an S corporation is allowed to have non-voting and voting shares, there cannot be different types of investors who gain access to different types of shares and/or dividends. Each share must be the same for all parties, whether they are an accredited investor or an employee exercising an option while making minimum wage. Only 100 total shareholders are allowed and no foreign ownership is permitted.
4. Tax filings are often highly audited.
The income of the S corporation is advantageous because of its pass-through nature, but this also means that money movement is closely analyzed by all tax reviewers at all levels of government. This is because funds can be distributed to a shareholder in the form of a dividend or in the form of a salary. These distributions can also be recharacterized, which can change employee tax liabilities or business deductions on dividend costs.
5. Allocating taxes and income is very inflexible.
With just one class of stock allowed, specific shareholders cannot assume specific profits or losses without undertaking a rather extensive assignment process that is often not worthwhile financially. Partnerships and LLCs can allocate with specificity through their operating agreement, which is why the S corp may not always be the right choice if one shareholder has more risk or investment than others.
6. Benefits can become taxable income.
If an employee owns more than 2% of the shares of an S corporation, then their benefits are considered to be taxable income. This includes any healthcare insurance payments, life insurance benefits, and even retirement distributions. Although these expenses are written off by the organization, the income still has to be reported through the individual’s returns and that can sometimes be a negative surprise when filing taxes.
The S corp pros and cons show that it can be an advantageous business structure for certain types of organizations. Maybe the S corp isn’t for the freelancer or the business of one or two, but for a company to grow and become profitable over time, the lack of personal liability for shareholders makes this structure quite attractive. Evaluate these key pros and cons and you’ll know whether or not this business structure is right for you.