There are advantages and disadvantages to forming an S corporation that are important for every small business owner to know when choosing a business structure. The primary advantages of this kind of for-profit corporation revolve around tax benefits. The main disadvantages of an S corp status are related to limitations placed on the business. The choice of whether to form this kind of corporation will ultimately depend on your goals and how fast you expect your business to grow.
Benefits of an S Corp Status
S corporations combine the advantages of small business structures and a corporate business structure, which can be particularly attractive for small-business owners.
Asset Protection
The main reason that small business owners incorporate rather than operate as a sole proprietorship or general partnership is that the owner's personal assets are protected. If the company were to become insolvent or subject to litigation, your bank accounts and home cannot be seized. Instead, only the company's assets are at stake.
Tax Advantages
While keeping your personal assets protected, S corporations enjoy several tax advantages that are not available to C corporations:
Pass-Through Taxation
At the federal level, C corporations are subject to double taxation. They are taxed once on their company profits and a second time on shareholder distributions. In contrast, S corporations don't pay taxes on company profits (with the exception of certain built-in gains and passive income). Instead, as a pass-through entity, the tax liability for business income (plus credits, deductions, and losses) goes directly to the employees and shareholders as it would for a sole proprietorship or general partnership.
An important note about state taxes: Please note that S corporations may be treated the same as C corporations at the state level. For instance, an S corporation located in Jacksonville, Florida, that pays income tax on line 22c of IRS Form 1120S must file a Florida Corporate Tax return and may be liable to pay corporate income tax at a rate of 5.5% for income earned on or after 1 January 2022. An accounting professional can explain whether this tax rate would apply in your case.
Advantageous Characterization of Income
The shareholders of an S corporation can be employees and receive salaries as well as receiving dividends and distributions in accordance with each shareholder’s basis in the S corporation’s stock.
As long as each shareholder-employee receives a "reasonable salary," the characterization of other income from the company reduces an owner-operator's liability for self-employment taxes. At the same time, paying wages creates tax deductions for the business owner.
Tax Savings on Health Insurance
An S corporation status is advantageous for health insurance premiums, as well. As long as a shareholder-employee's spouse isn't eligible for subsidized health insurance, he or she can have the S corp pay family health insurance premiums as part of his or her wage package.
For both the employer and the employee, the amount paid on health insurance can be deducted from the employee's income before calculating self-employment tax. The amount paid is also deductible for the employer as a wage expense and therefore isn't subject to taxation.
Employee Expense Reimbursem*nts
Employees can no longer take business expenses as a tax deduction with the Internal Revenue Service. However, they can be reimbursed for these expenses by the S corporation using an Accountable Plan.
Under the plan, each employee can keep track of business-related expenses such as home office rent, mileage, and business phone and request reimbursem*nt from the corporation. The amounts reimbursed can then be categorized by the corporation as business expenses and taken as tax deductions.
It's important for S corporation owners to note that paying employees extravagant amounts in reimbursem*nts could trigger an IRS audit process and potentially lead to tax debt. It's important to ensure that all reimbursem*nt requests are substantiated with receipts and that any excess payment amounts be returned to the corporation.
Retirement Contributions
Corporation shareholders who are employees can divert up to 25% or $66,000 per year (for 2023) of their salaries—whichever is smaller—to a SEP IRA (simplified employee pension individual retirement account) and deduct the amount of the contribution from their taxable income. Taxes will be paid on the distributions of these funds at the rates set for the relevant year.
Easier Accounting
In business accounting, there are two ways to report income and expenditure:
The cash-basis method
The accrual method
Whereas C corporations have to use an accrual basis for accounting, S corporations can use a cash basis instead. This simplifies S corporations’ small business accounting and tax planning significantly.
More Credibility and Prestige
While a single owner-operator could trade as a sole proprietor, forming an S corporation increases prestige and trust with partners, employees, customers, and suppliers. Because of the detailed process that goes into setting up an S corp, others can see that you have a well-thought-out plan with checks and balances and will see you as a serious business.
It's Easy to Transfer Ownership
When it comes time to sell your S corporation, interests can be transferred to the new owner(s) without any complicated or expensive tax ramifications. Unlike sole proprietorships, S corporations can also continue past the owner's lifetime, which is an advantage if the owner wants to arrange for a succession or sale of the business upon retirement.
Disadvantages of an S Corp Status
Along with the benefits listed above, there are a few disadvantages of forming an S corporation compared to other business structures. However, for most people, the advantages outweigh the drawbacks.
Multi-Step Setup Process
Forming an S corporation involves more steps than forming a sole proprietorship, partnership, or limited liability company (LLC). You'll need to write articles of incorporation and corporate bylaws, appoint a board of directors, run shareholder's meetings, and keep a record of minutes for certain company meetings.
More Vulnerable to IRS Tax Audits
The advantageous tax status of S corporations means that they are often under closer scrutiny than C corporations with the IRS. You can generally avoid problems by making sure each shareholder-employee is paid a reasonable salary before distributions and that all reimbursem*nt requests are substantiated and accurate. These tips for easier bookkeeping can help you keep accurate records.
More Limitations than C Corporations
There are several S corporation requirements that must be met in order to keep your filing status and the associated tax benefits. Failing to abide by any of these requirements can result in you being reclassified as a C corporation. The good news is that any mistakes can usually be fixed quickly to keep your S corporation status. And if you do want to start attracting corporate investors, changing to a C corporation is easy to do.
S Corporations: The Ideal Solution for Many Small Businesses
As a certain type of small business corporation, an S corp offers many advantages in the form of tax benefits, liability protection, increased prestige, and generous retirement contribution limits.
The main disadvantages are a fairly involved setup process and requirements that must be carefully followed.
However, with professional advisors, careful bookkeeping and accounting, and careful management, owner-operators have much to gain.
