Pros of an S Corp

S Corporations offer several advantages if your company qualifies:

• Tax advantages: S Corporations are exempt from federal income tax except for certain capital gains and passive income. Similar to the LLC, the S Corporation allows profit to pass through to its shareholders, and the income is then taxed on the shareholders’ personal tax returns at each shareholder’s individual tax rates. Because the S Corporation is a pass-through entity, this ensures that the corporation’s profits are only taxed once – at the shareholder level. This means that S Corporations avoid having to pay what is often referred to as “double taxation” of dividends found with C Corps.                                                                       
• Asset protection: If your business is an S Corporation, you have certain legal protections for your personal assets which are separate from the assets of the business. For example, shareholders are not personally liable for the company’s debts or liabilities, and luckily for the most part, creditors are not able to go after the shareholders’ personal assets in order to recover business debts.
• Flexible characterization of income: Being an owner of an S Corporation gives you flexibility in how to characterize your income for tax purposes. As the owner/shareholder of an S Corp, you can be an employee of the business and pay yourself a salary. In addition to your salary, you can also pay yourself dividends from the S Corporation or distributions that are generally tax-free or taxed at a lower rate than the employee’s salary. This helps you reduce your self-employment tax liability, as long as you are characterizing your salary and dividends/distributions in a reasonable way. The IRS does not want to see you paying yourself an artificially low salary in order to avoid paying self-employment taxes on the “dividend/distribution” portion of your income.
• Easy transfer of ownership: S Corporation ownership interests are easy to transfer to other owners without causing significant tax consequences or terminating the corporate entity. An ownership transfer of an S Corporation does not require adjustments to property basis or compliance with complicated accounting rules.

Cons of an S Corporation

The S Corporation structure is not right for every business’s situation, and it presents certain drawbacks and downsides:

• Restrictions on Ownership: S Corporations do not have the same degree of flexibility in their ownership structure, compared with a C Corporation. S Corps can only offer one class of stock, which limits the appeal to different types of investors. Also, the S Corp can only have 100 shareholders (or fewer) and cannot be owned by foreign shareholders or by certain trusts or other corporate entities.
• Caution about Wages and Dividends: One of the great aspects of the S Corporation is its flexibility in characterizing income as wages or dividends, but this can also present challenges. The IRS is always on the lookout for business owners that are not fairly or accurately characterizing their payments of wages, so as an S Corporation owner, you have the risk of being asked to re-characterize some of your income and pay higher taxes as a result.
• Tax Qualification Mistakes: This is a rare scenario, but it does happen – sometimes, S Corp owners will make mistakes related to their IRS form filing requirements related to stock ownership, election, consent, notification and other aspects of running an S Corp, and this can cause the company to lose its S Corporation status.

Would you like to set up your business as an S Corporation, or set up your LLC to file as an S Corporation? If so, you can choose S Corporation status for tax purposes by filing IRS Form 2553 within 75 days of the filing date of the company or by filing IRS Form 2553 by March 15 of the tax year the election is to take effect, or any time during the tax year prior to the tax year it is to take effect.

You can learn more about S Corporations in our article about Understanding S Corporations or you can being the process of setting up your own S Corporation on our registration form.