Forming an S Corporation: Pros and Cons
One of the most important decisions you’ll make as an independent professional is choosing the right business structure for your company. There are many options for independents, each with different taxes, paperwork, and levels of risk.
What is an S Corporation?
An S Corporation is a business structure similar to a C Corporation in that they are both unique corporate entities, separate from their owners. With an S Corporation, shareholders report business income, losses, deductions, and credits on their personal tax returns—taxed at their individual income tax rates—thereby avoiding double taxation on corporate income.
S Corporation Advantages
1. Limited Liability Protection
Similar to a C Corporation, with an S Corporation your liability is limited to the percentage of the company you own. Separating your personal assets from your professional assets can be beneficial in the case your company is ever sued.
2. Pass-Through Taxation
With an S Corporation, the business itself is not taxed. Instead, profits and losses are passed through to shareholders and paid at the individual level on their personal tax returns. Remaining profits can be distributed to shareholders as distributions, which are not subject to Social Security and Medicare taxes.
3. Stock Options
S Corporations can sell shares of company stock, which can help raise capital. The procedure for issuing shares of stock is relatively simple. However, only one class of stock is available which may also discourage some investors.
4. Perpetual Existence
Similar to C Corporations, S Corporations can live on indefinitely. If a corporation owner were to pass away or leave, the corporation could continue to exist. This makes it easier to transfer stock or shares to individuals in the future, or sell the S Corporation altogether.
S Corp Disadvantages
1. Reasonable Compensation
Any shareholder who works for an S Corporation must pay themselves “reasonable compensation.” The IRS deems reasonable compensation to be a fair market value—what a person with the skills needed for the position would be paid on the free market. If the IRS finds that shareholders are not paid reasonable compensation, they can reclassify any additional corporate earnings and wages, and in that case, you will have to pay Social Security and Medicare taxes. The IRS pays particular attention to owners of S Corporations who try and pay themselves a lower wage to avoid this tax.
2. Strict Guidelines
Profits and losses must be distributed to shareholders in proportion to their stake in the company. For example, if you own 25% of the company, you must receive 25% of the company’s profits or losses. Higher-income shareholders will pay more taxes on their distributions.
3. Professional Services Corporation Designation
Single owners of S Corporations are seen as a Professional Services Corporation (PSC) by the IRS. All profits from a PSC are subject to SE tax. There is a large audit risk for PSCs.
4. Maintenance Cost
S Corporations must file a number of state and federal documents and pay government fees to maintain their status. Because S Corporations are created by individual states, there may be additional state taxes and regulations as well.
5. Ownership Restrictions
S Corporations are limited to a maximum of 100 total shareholders.
Should you be interested in setting up your own S corporation or other business structure, give us a call. We’re happy to walk you through the process.
The information provided in the MBO Blog does not constitute legal, tax or financial advice. It does not take into account your particular circumstances, objectives, legal and financial situation or needs. Before acting on any information in the MBO Blog you should consider the appropriateness of the information for your situation in consultation with a professional advisor of your choosing.