Advantages and Disadvantages of S Corporation (S Corp)
A Small Business Corporation, aka S Corporation, is the second-best option for business owners next to proprietorship. S Corporations are legal business entities that you can start with one or many owners. The legally-bound business is the best option to switch to when your business starts making you profit under a sole proprietorship. However, if you decide to migrate your business from a sole proprietorship to S Corp, considering the Advantages and Disadvantages of S Corporation is a good move.
What is an S Corporation?
An S Corporation(S Corp) or Small Business Corporation is a type of business that allows taxation of the company similar to a partnership or sole proprietorship. By forming an S Corp, you don’t have to pay taxes as you’d have to on a corporate tax structure.
An S corporation is created through filing Articles of Incorporation with the Secretary of State or similar government authority. The S corporation issues stock comprises of directors, officers, and shareholders. All these persons are responsible for functioning of S corporation as a single unit.
Unlike proprietorship, An S corporation shareholder’s personal assets, such as personal bank accounts, cannot be seized by the debtors or banks to satisfy business liabilities.
What are the Advantages of S Corporation (S Corp)?
Upgrading your business from a sole proprietorship to S Corporation these days is easier due to the different rules and regulations. There are many advantages of S corporations in general or as compared to other businesses.
1. Asset Protection
If you are a shareholder in an S corporation, your personal assets are protected. A shareholder in an S Corporation does not have personal liability for the business debts and liabilities. Lending banks or creditors haven’t a right to pursue any shareholder's personal assets, whether house or bank accounts, to clear business debts. However, you are vulnerable to lose your personal assets in case of a sole proprietorship or general partnership.
2. Pass-through taxation
An S corporation is not obligated to pay federal taxes at the corporate level. This means any business profit or loss is "passed through" to shareholders who specify it on their personal income tax returns. This means you can save your individual income tax to a specific limit despite having a loss in business. This can be extremely helpful in the startup phase unless you have a personal holding company.
3. Tax Saving on Personal Income
S corporation shareholders can be employees of the business and draw salaries as employees. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation. A reasonable characterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability, while still generating business expense and wages-paid deductions for the corporation.
4. Ownership can be Transferred Easily
You can transfer ownership in an S Corporation, mitigating termination risks. Protection from claims is impossible if an LLC as transferring more than 50% interest can lead to the termination of the business entity. I an S corporation, you don’t need to make any property-based adjustments or comply with complicated accounting rules.
What are the Disadvantages of S Corporations?
There can also be Disadvantages of S Corporations in business that apply to both shareholders and the corporations. Most commonly, you may come across major-to-minor setbacks in the initial phases. The major pitfalls of S Corporations can also emanate while handling taxes and complying with state policies.
1. S Corporation is Difficult to Form
It is essential to pitch the idea and incorporate the business by filing Articles of Incorporation with your respective state authority to get an S incorporation. The next step is to obtain a registered agent for your corporation and pay the requisite fees. Many state authorities impose additional costs on annual reports and franchise tax fees. Even though these fees are light to bear for partners and shareholders, sometimes, it becomes difficult for a sole proprietor to incur when they are already running on a tight budget. Given stricter rules to comply with, corporation owners may also have to go through rigorous stages during the initial form processing.
2. Risks of Termination
There are stricter regulations and protocols you are obligated to follow once you register as an S Corporation. Inability to abide by the bylaws and keeping the business in terms with the state can be the biggest of the disadvantages of S Corporation. Even though you are least likely to mistake filing, making obligations mistakes regarding the various election, consent, notification, stock ownership, and filing requirements accidentally are some of the risky factors in S corporation. A minute mistake can lead to termination.
3. Double taxation
As discussed above, corporations are separate entities; that’s why many opt to go for it for various reasons. However, this also means that an S corporation, as a separate entity, will be bound to pay its taxes timely. Once a corporation is taxed, it can distribute the earnings to its shareholders via dividends.
The dividends are then re-taxed for each shareholder individually. This eventually means that the earnings made by shareholders through corporations are subject to double taxation.
4. Corporation are Subject to IRS Audits
Since the earned amounts are distributed to a shareholder through dividends or salary, the IRS scrutinizes payments to ensure the entered records meet the actual statistics. As a result, wages may be reorganized as dividends, costing the corporation a deduction for compensation paid. Conversely, dividends may be depicted as wages, which subjects the corporation to employment tax liability.
To reduce S Corporation's hassles and shortcomings, it’s a bright idea to launch yourself as a sole proprietor. However, if your business grows better than expected, the ultimate wise decision is to switch to an S corporation. Converting your small business into it gives you options to raise capital, attract new shareholders, and provide personal asset protection for the owners.