Benefits of S Corp: Corporation Advantages and Disadvantages

What defines an S corp?

The distinguishing feature lies in the tax benefits of an S corp. It receives its name from its choice to be taxed according to the Internal Revenue Code’s Subchapter S, positioning it as a “flow-through” structure for tax reasons. It otherwise functions as a for-profit corporation, established and regulated according to the same state laws concerning corporations as a C corp (or a corporation that either did not qualify for S corp tax designation or whose shareholders decided against electing that status).

In terms of liability protection, management advantages, and ownership, an S corporation mirrors those offered by a C corporation, which is taxed according to the Internal Revenue Code’s Subchapter C. This is good news for an entrepreneur interested in the tax benefits of an S corp.

What are the benefits of opting for an S corp?

Below are a few of the common benefits of S Corp that come with choosing this structure, such as the tax benefits of an S corp. However, it is crucial to consider your immediate and future objectives, as what may be an advantage in one business scenario could potentially become a drawback for an S corp in another.

For instance, benefits of S Corp flow-through taxation is generally seen as favorable due to its lower tax implications. Yet, if a company aims to accumulate funds for expansion, like constructing a new location, a C corp might be a more suitable option since earnings can be kept within the company.

1. Shielding of Assets

Other than the tax benefit of S corp, this structure offers a significant advantage in the form of limited liability protection for owners. This protection ensures that the personal assets of owners are safeguarded from claims made by creditors, whether those claims arise from legal disputes or contracts. It is worth noting that every corporation, including limited liability companies, extend limited liability protection.

2. Flow-Through Taxation

One of the tax benefits of S corp lies in the fact that business earnings, along with numerous tax credits, losses, and deductions, are passed on to the owners instead of being subject to corporate-level taxation. This circumvents the potential for “double taxation,” a scenario encountered by C corporations where dividend income is initially taxed at the business level before being taxed again at the shareholder level. This is due to the S corp’s status as a flow-through entity for federal (and the majority of state) income tax reasons. It is worth mentioning that an LLC also operates as a flow-through tax entity, though it can choose to be taxed like a C corporation if deemed more beneficial for the company by its owners.

3. Compensation Distribution

An owner of an S corp has the option to receive compensation in the form of both dividends and salary from the company. This choice can lead to a reduced overall tax liability — another tax benefit of S corps.

Why does this work? Self-employment tax does not apply to dividends. In addition, the S corp can account for the paid wages when calculating the portion of income passed on to the shareholders.

That said, it is crucial for the allocation between dividends and salary to be deemed “reasonable” by the Internal Revenue Service. (The IRS closely scrutinizes these kinds of transactions and will intervene to reclassify the earnings if it deems the payments to be unreasonable).

4. Conversion Simplicity

Obviously, one of the main attractions are the tax benefits of S corp. In the event that S corp shareholders wish to transition to C corporation taxation, they simply need to file this election with the IRS. Likewise, an LLC taxed as a flow-through entity that desires to be taxed in the manner of a C corp may make a straightforward filing with the Internal Revenue Service. That said, if LLC owners wish to convert their limited liability company into either a S or C corporation, they must adhere to the regulations of both their state’s LLC and corporation laws and submit appropriate documents to the state. These filings encompass formation filings, dissolution/withdrawal documents, and more.

What are the drawbacks of an S corp?

While entrepreneurs may be drawn to the tax benefits of S corp, as previously mentioned, certain advantages can pose challenges for specific business types and strategies. The following are a few of the difficulties associated with being an S corp, in addition to the inherent issues that come with operating in the manner of a corporation instead of the more adaptable LLC.

1. Stringent Eligibility Criteria

To qualify for S corporation status and the tax benefits of S corp, and to maintain that status, the corporation needs to adhere to strict requirements regarding the nature and number of shareholders, as well as the share types. These regulations are dictated by federal tax law, rather than state corporation law. In summary, these stipulations include:

• Only individuals, specific trusts and estates, and specific tax-exempt entities may act as shareholders.
• The number of shareholders cannot exceed one hundred (although certain members of a family can be considered one shareholder).
• There may be only a single stock class (although variations in voting rights are allowed).

A limited liability company can function as a flow-through entity while avoiding limitations. In addition, even though both an LLC and a S corporation operate as flow-through structures, they are taxed according to separate sections of the IRC, resulting in distinct tax treatments.

2. Inflexible Loss and Profit Allocation

Due to its corporate structure, an S corp is obligated to distribute losses and profits among owners strictly based on their ownership percentage or the quantity of shares held. Conversely, an LLC has the flexibility to allocate its losses and profits in proportions determined by the owners’ preferences.

This means that a founding owner who gives fifty percent ownership to a brand new owner might get a disproportionate share of the LLC’s income. In an S corp, the founders’ share is adjusted from one hundred percent to fifty percent.

3. Compliance with Corporate Procedures

The tax benefits of an S corp can be blinding; it is important to bear in mind that an S corp fundamentally functions as a corporation. Consequently, it must adhere to all the relevant procedures mandated by the corporation statute of its domicile state. In contrast, state laws governing LLCs impose considerably fewer regulatory formalities.

Both LLCs and corporations are obligated to register for business operations in states beyond their original jurisdiction.

Conclusion

In conclusion, do not simply focus on the tax benefits of S corp. Be sure to weigh the pros and cons of S corporations in light of your specific business requirements.

To be sure, it is tempting to focus on the tax benefits of an S Corp. Opting for an S corporation can be advantageous if you seek a business structure that combines the benefits of a corporation with flow-through taxation. Nevertheless, it is crucial to meet and uphold the necessary requirements for the election to be considered valid. It is also important to consider that while being a corporation offers certain advantages, it comes with a trade-off in terms of flexibility and the greater formalities it entails compared to an LLC.