S Corporation Advantages and Disadvantages
The S-corporation is a popular entity type for small businesses. While its popularity indicates that consideration of using an S corporation is certainly wise, “going with the crowd” is not always the best choice. It is important to understand what is right for your business and your unique circumstances. We have presented below some of the advantages and disadvantages of using an S-corporation as your entity of choice.
- Liability protection. Your personal assets will not be at risk (unless you pledge assets or personally guarantee the corporation’s debt).
- Single level of tax. The S-corporation does not pay federal tax. Instead, the corporation’s income and deductions are passed through to the shareholders and are claimed on your individual returns. Depending on your state, the corporation may pay a tax to the state, but usually at a lower rate than regular corporations.
- No self-employment tax. Social security and Medicare taxes are not owed on the regular business earnings of the corporation, only on salaries paid to employees. This is a potential advantage over sole proprietorships, partnerships, and limited liability companies.
- Restrictions on shareholders. S-corporations cannot have more than 100 shareholders. Corporations, nonresident aliens, and most estates and trusts cannot be S corporation shareholders.
- Single class of stock. S-corporations can have only one class of stock (although differences in voting rights are permitted). This severely limits how income and losses of the corporation can be allocated among shareholders.
- Shareholder’s Basis. Unlike a partnership or LLC, an S-corporation’s owner’s basis in the corporation does not include any of the corporation’s debt, even if the shareholder has personally guaranteed it. This has the effect of limiting the amount of losses that can be passed through.
- Fringe Benefit Restrictions. S-corporation shareholder-employees with more than a 2% ownership interest are not entitled to most tax-favored fringe benefits. This includes health insurance, group term life insurance, and dependent care benefits that may be provided tax-free to non-shareholder employees. However, some of the benefits may be available at the individual return level.
- Built-In Gains Tax. If the entity was formerly a C-corporation prior to electing S-corporation status, it may be liable for a tax on the unrealized gains in its assets. This is a complex subject and should be a point of consideration if your business is currently a C-corporation.
This is not a complete list, and we urge you to give us a call to help you determine whether an S-corporation is the right type of entity for your business.
Mike Trank- is a Tax Partner at Wertz & Company, LLP, a Professional Services Firm located in Orange County, CA that specializes in working with entrepreneurs along their journey to success.