An S corporation is often recommended when small business owners seek advice regarding how to structure their business. An LLC is also often recommended. So which is better?
The fact is, there’s no one perfect choice. Whether you should become an S corporation depends on many factors, including the type of business, the plans for the business and the short- and long-term goals of the owners.
This article will help you understand the advantages and disadvantages of an S corporation—an important first step to determine if this is the right business structure for your company.
What is an S corporation?
The key feature that distinguishes an S corporation is the tax advantages it offers. It’s called an S corporation because it has elected to be taxed under Subchapter S of the Internal Revenue Code, making it a “pass-through” entity for tax purposes. Otherwise, it’s a for-profit corporation, incorporated under and governed by the same state corporation laws as a C corporation (or a corporation that was not eligible for S corporation tax status or whose shareholders chose not to elect that status).
An S corporation offers similar liability protections, ownership, and management advantages as a C corporation. (A C corporation is taxed under Subchapter C of the Internal Revenue Code.) Learn more about C corporation tax advantages and disadvantages.
What are the advantages of an S corporation?
Here are some of the most frequently cited advantages that an S corp can offer its owners. You should be clear on your immediate and long-term goals, however, as an advantage can turn into an S corp disadvantage in some business situations.
For example, pass-through taxation generally is positive because it results in less taxation. But if a business goal is to accumulate money for expansion—perhaps to build a new facility—a C corporation could be the better choice because income can be retained within the corporation.
1. Asset protection
One major advantage of an S corporation is that it provides owners limited liability protection, regardless of its tax status. Limited liability protection means that the owners’ personal assets are shielded from the claims of business creditors—whether the claims arise from contracts or litigation. In fact, all corporations, as well as LLCs, provide limited liability protection.
2. Pass-through taxation
The tax benefit for S corporations is that business income, as well as many tax deductions, credits, and losses, are passed through to the owners, rather than being taxed at the corporate level. This avoids the chance of “double taxation” which occurs with C corporations when dividend income is taxed first at the corporate level and then at the shareholder level. This is because an S corp is a pass-through entity for federal (and most state) income tax purposes. An LLC is also a pass-through tax entity. Note that it can elect to be taxed as a C corporation if business owners determine that is in the company’s best interests.
3. Salary and dividend payments
An S corporation owner can opt to receive both salary and dividend payments from the corporation. This can result in a lower tax bill overall.
Why? This is because dividends are not subject to self-employment tax. Further, the S corporation can deduct the cost of the wages paid when computing the amount of income that is passed through to the shareholders.
However, the division between salary and dividends must be “reasonable” as determined by the IRS. (The IRS watches these types of transactions very closely and will step in and re-characterize the income if it feels the payments were unreasonable).
4. Ease of conversion
If S corporation shareholders want to be taxed as a C corporation, all that’s required is filing this election with the IRS. An LLC that is taxed as a pass-through but wants to be taxed as a C corporation can also simply make a filing with the IRS. However, if the LLC owners want to convert their LLC into a C or S corporation, they will have to comply with both their state corporation and LLC laws and file documents with the state. These filings include dissolution/withdrawal filings, formation filings, and more.
What are the disadvantages of an S corporation?
As noted earlier, some advantages can function as disadvantages for certain types of businesses and business plans. Here are some of the challenges of being an S corp, as well as some issues that are inherent in operating as a corporation, rather than the more flexible LLC.
1. Strict qualification requirements
In order to be eligible to make an S corporation election—and to continue to be an S corporation—the corporation must meet strict requirements on the number and type of shareholders and types of shares. These rules are imposed by federal tax law, and not state corporation law. Briefly stated, these rules include the following:
- Only individuals, certain estates and trusts, and certain tax-exempt organizations can be shareholders
- There cannot be more than 100 shareholders (although some family members can be counted as a single shareholder)
- There can only be one class of stock (although differences in voting rights are permitted)
An LLC can be a pass-through entity without being subject to those restrictions. And although both an S corporation and an LLC are pass-through entities they are taxed under different sections of the Internal Revenue Code, so their taxation is not identical.
2. Rigid profit and loss allocation
Because it is a corporation, an S corporation is required to allocate profits and losses among the owners based strictly on the percentage of ownership or number of shares held. In contrast, an LLC is able to allocate its profits and losses in whatever proportions the owners desire.
Thus, the founding owner who transfers 50 percent of the ownership to a new member could receive a disproportionate share of the income from the LLC. In an S corporation, the founders' allocation is reduced from 100 percent to 50 percent.
3. Corporate formalities
Remember that an S corporation is first and foremost a corporation. This means that it must observe all the corporate formalities imposed by its home state’s corporation statute. In contrast, the state LLC laws impose far fewer statutory formalities. Learn more about LLCs in the LLC Handbook.
Both corporations and LLCs must register to do business in states outside of the home state.
Bottom line: Consider the advantages and disadvantages of S corps against your business needs
S corporations can be the right choice if you are looking for a company structure that provides the advantages of a corporation along with pass-through taxation.
However, there are requirements that must be met in order to make the election and they must continue to be met for the election to remain valid. The advantages of being a corporation must be balanced against the lack of flexibility and the more extensive formalities imposed on a corporation versus an LLC.