An S-corporation, also known as an S-corp or S subchapter, is a type of business entity that provides the benefits of limited liability protection and the ability to pass its taxable income, deductions, and losses directly through to shareholders of the business.
To qualify as an S-Corp, a business must meet several criteria, including being a domestic corporation, having no more than 100 shareholders, having only eligible individuals or certain trusts as shareholders, and issuing only one class of stock. Additionally, all shareholders must be U.S. citizens or residents. Like an LLC, S-corporations are pass-through entities. The business itself does not pay corporate taxes, but instead pay their shareholders, who would then report that come on their personal tax returns.
Pros of running a business as an S-corporation
Limited liability protection
One of the main advantages of forming an S-corporation is the limited liability protection it provides to shareholders.
S-corps enjoy a pass-through taxation structure, where business profits and losses are passed through to the individual shareholders. This means that the S-corp itself is not subject to federal income tax. Instead, shareholders report their share of the company’s profits and losses on their personal tax returns.
Self-employment tax savings
Another tax advantage of S-corps is the potential to save on self-employment taxes. Unlike sole proprietorships or partnerships, where all business income is subject to self-employment tax, S-corp shareholders can receive a portion of their income as distributions rather than salary. Distributions are not subject to self-employment tax, reducing overall tax liabilities.
Operating as an S-corporation may enhance the credibility and perceived stability of a business. The structure implies a higher level of professionalism and organizational structure, which can be more appealing to clients, vendors, and investors.
Ease of transferability
S-corps offer more flexibility in transferring ownership than some other business entities. Shares can be easily transferred to new shareholders, facilitating investment opportunities and potential business growth (which can also help with succession planning).
Cons of running a business as an S-corporation
Eligibility and restrictions
While S-corps offer several benefits, they have certain eligibility requirements and restrictions. For instance, an S-corp can only have a maximum of 100 shareholders, and they must all be U.S. citizens or residents. Unlike an LLC or C-corporation, non-individual entities, such as partnerships or corporations, cannot be shareholders. These restrictions may limit the scalability and potential sources of capital for the business.
Formalities and administrative burden
Compared to simpler business structures like sole proprietorships or partnerships, S-corps typically have more administrative requirements. This includes regular board meetings, annual shareholder meetings, and proper maintenance of corporate records. Failing to comply with these formalities may risk losing the S-corp status and associated tax benefits.
Stricter profit distribution rules
S-corps have specific rules for distributing profits to shareholders. Unlike partnerships or LLCs, which allow flexible allocation of profits, S-corps must distribute profits to shareholders based on their ownership percentage. This lack of flexibility may not suit businesses with shareholders who have varying levels of involvement or capital investment.
Payroll taxes and reasonable compensation
S-corps are subject to payroll taxes on wages paid to shareholders who are active in the business. The IRS requires that shareholders receive “reasonable compensation” for the services they provide.
S-corporation vs C-corporation
- Taxation: The most significant difference between S-corps and C-corps is their tax treatment. S-corps are pass-through entities, meaning they do not pay federal income tax at the corporate level. Instead, the profits and losses of the business pass through to the individual shareholders, who would then report them on their personal tax returns. This results in avoiding double taxation. In contrast, C-corps are subject to double taxation, as they are taxed at the corporate level, and the shareholders are also taxed on any dividends or distributions they receive.
- Ownership and shareholders: S-corps have restrictions on ownership and shareholders. An S-Corp can only have a maximum of 100 shareholders, and all shareholders must be U.S. citizens or residents. On the other hand, C-corps can have an unlimited number of shareholders, including non-U.S. citizens, foreign entities, and other corporations.
- Formalities and administrative requirements: S-corps typically have fewer administrative requirements compared to C-corps, which are subject to more extensive record-keeping, reporting, and compliance obligations. They must hold regular board meetings, keep detailed corporate records, and comply with additional regulations and filing requirements. S-corps still have some administrative requirements, such as annual shareholder meetings and maintaining corporate records, but considerably less than C-corps.
- Profit distribution: S-corps and C-corps have different rules for profit distribution. S-corps must distribute profits to shareholders based on their ownership percentage. This means that distributions are typically proportional to each shareholder’s investment or ownership stake. In contrast, C-corps have more flexibility in distributing profits. They can allocate dividends and distributions to shareholders in a manner determined by the board of directors, allowing for different classes of stock and varying distribution preferences.
- Perpetual existence and transferability: Both S-corps and C-corps have perpetual existence, meaning they can continue to operate even if shareholders leave or new shareholders join. However, S-corps have more restrictions on transferring ownership. Shares of S-corps can only be transferred to eligible individuals, subject to certain limitations. C-corps, on the other hand, have more flexibility in transferring ownership, as shares can be freely bought and sold without restrictions.