S Corp Advantages and Disadvantages

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The S corporation (S corp) tax designation offers some excellent opportunities to potentially save money on taxes. However, it also carries additional scrutiny come tax season as well as other complications. This guide will cover the key advantages and disadvantages of electing S corp status to help you determine if an S corp is right for you.

What Are S Corps?

An S corp isn’t a formal business structure but rather a tax designation. Limited liability companies (LLCs) and corporations can elect S corp tax status.

With an S corp tax designation, the Internal Revenue Service (IRS) will consider the business’s members and owners who also serve as directors, managers, or other roles within the company as employees. As a result, they must receive a reasonable salary and may also take distributions from the company. 

  • A reasonable salary is a fixed amount that should be comparable to what you’d pay for a similar service in the area. Salaries are subject to both employment and income tax.
  • Distributions are profits and losses the company passes through to its shareholder(s). They’re only subject to income tax.

S Corp Advantages

S corp status can provide many benefits to companies and may make an excellent choice for some business owners. Here are the key benefits of electing an S corp tax designation for your business: 

  • Tax Advantages: One of the primary advantages is the ability to take distributions in addition to your salary. Because the IRS doesn’t consider distributions as wages, you don’t have to pay employment tax on them. Therefore, if you take enough in distributions, you could potentially save a lot of money in taxes. Similarly, because an S corp passes its profits and losses through to its owner(s), the business isn’t taxed at the corporate level. Therefore, corporations that elect S corp status avoid double taxation.
  • Flexibility: Another advantage is the ability to be flexible with your salary as your company grows. If you choose not to take distributions, you also can elect not to pay yourself a salary — or pay yourself a lower-than-average salary.
  • Easy Termination: Should you decide S corp status is no longer for you, it’s easy to terminate your S corp tax designation. All that’s required is a vote of shareholders who hold 50% or more of the voting shares.
  • Ability to Issue Stock: LLCs that elect S corp status can issue stock. This can prove beneficial for businesses in their early growth phases that need to use equity to build a team.

S Corp Disadvantages

The S corp tax designation also comes with a unique set of challenges outside the normal range you might expect of an LLC or standard corporation. These include:

  • Ambiguous Guidelines and More Scrutiny: One of the primary disadvantages of S corp status is that many of its requirements lack clear guidelines, such as on how to determine a reasonable salary or how much to take in distributions. Additionally, you can lose your S corp status if you fail to follow and meet certain guidelines set by the IRS — even if you do so unintentionally.

S corp status also can lead to higher IRS scrutiny, meaning you must be especially scrupulous in deciding how much to pay yourself and how much to take in profit distributions. 

  • Greater Complexity: S corp status comes with increased paperwork and effort at tax time. Specifically, S corps must file the following at the end of each tax year: 
    • Schedule K-1 This form lists what each shareholder made in profits or losses from the company in a given tax year. If you took distributions from your S corp, you must report them on your Form 1040.
    • Form 1120S (US Income Tax Return for an S Corporation) — This is the form S corps use to report the business’s income, gains and losses, tax credits, and tax deductions.
    • Form W-2 (Wage and Tax Statement) — This form reports an employee's income and all taxes withheld from their wages.
    • Form 1040 (US Individual Income Tax Return) — This is your personal income tax return. To complete this form, you’ll need to:
      • Use your Form W-2 to report your S corp salary.
      • Use Schedule E to report and pay personal income taxes on your S corp distributions.

Hiring a competent accountant can help you file the correct forms for your company on time. S corps also follow a calendar year for tax purposes vs. a fiscal year unless they can make a reasonable argument to the IRS for adopting a fiscal year model.

  • Limited to One Class of Stock: S corps may only issue one class of stock, which must have identical rights and dividends. This can make raising money through the sale of stocks quite difficult. It also means S corps can’t allot losses or profits to certain stockholders. Allocations are solely determined by stock ownership — unlike a partnership or LLC, where you can allocate profits and losses based on partnership agreements.

S corps also have a number of restrictions on who can be a shareholder. S corp shareholders must be US citizens as well as private citizens. Foreign citizens and entities or corporate shareholders aren’t allowed.

Is an S Corp Right for Me?

The S corp tax designation can offer many benefits but not without a few challenges. If your S corp earns enough revenue and you can collect a reasonable salary and take distributions — and it’s capable of handling the added tax burdens — electing S corp status could very well be the right fit for you. 

Ready to start your S corp today? Check out our How to Start an S Corp guide to learn more.