Forming an S Corporation: Pros and Cons

The S corporation is one of the most often-misunderstood business structures. Even though the structure of the S corp may seem complicated, the unique set of benefits offered by an S corp make understanding these complexities well worth the effort. Many entrepreneurs find that the S corp is the ideal choice for them. Is it right for you? Read ahead for more information.

The basics

The structure of an S corporation (often abbreviated “S corp”) is unique in that it has a limited ability to distribute stock, but still is eligible for pass-through taxation status. No other type of corporate structure allows this.

Like any form of incorporation, filing and maintaining an S corp requires an owner to complete a substantial amount of paperwork, pay fees, and organize their business via administrative efforts. The effort required to establish an S corp is one of its biggest drawbacks, however it can be largely negligible for most large organizations. Smaller businesses may choose to use an established filing service to efficiently complete the paperwork for them.

The benefits

The specific advantages that S corps offer their owners include:

Personal asset protection After successfully filing, an S corp becomes a completely separate legal entity from its individual owners and shareholders. This grants the business limited liability protection status, which prevents courts from pursuing any owner or shareholder’s personal assets to pay debts held by the business.

Added credibility Successful incorporation shows that the S corp in question has gone through the legal and regulatory process required during filing. This sends the positive message to potential clients or associates that the company is organized and more likely to be reliable. S corp status also shows potential creditors that the company can be trusted.

Relatively streamlined ownership transfers While there are still some restrictions placed on who can become part of an S corps ownership structure, the actual transfer of ownership is a much more streamlined process, as compared to other structures (LLCs, general partnerships, etc.). This can benefit owners and shareholders during the sale of interest.

Income can be favorably characterized for tax purposes The owners of an S corp can also be categorized as employees of the company. This benefit favorably impacts an owner’s taxes in two ways. First, the owner is able to greatly reduce his or her self-employment tax burden. Secondly, the owner is also eligible to draw a salary and receive benefits as an employee. Creating an owner salary results in an expense in the ledger, therefore less net profit to pay taxes on, while sill transferring funds to the owner.

The drawbacks

Recurring paper work and expenses S corps require a great deal of paperwork, observation of certain formalities, and payment of associated fees. Along with C corps, S corps typically can’t avoid any of these duties. Some smaller organizations might have a difficult time staying compliant with these requirements.

Ownership restrictions Even though S corps center their ownership on stock distribution, there are some strict restrictions in place that limit who can purchase or hold shares in the company. An S corp’s ownership is limited to 100 different individuals, who all must be United States citizens. Other businesses and trust organizations are also restricted from becoming owners of an S corp.

Increased governmental observance Due to the unique set of realities of an S corp, the IRS tends to keep a very close eye on all of the major financial decisions that they make. In the event of an audit, the IRS may force an S corp to reclassify many of their beneficial income distribution decisions with a great deal of scrutiny.

Less income and loss allocation options An S corp's ownership is based around one class of stock, which can make it extremely difficult to attribute certain profits and losses to individual owners. As a result, the owners of an S corp are typically forced to receive a portion of the company’s profits (or losses) in a very uniform manner. No other form of organization faces this potential problem.  

Potential tax qualification issues The unique set of requirements placed on the ownership and formation of an S corp create a great deal of room for errors during the filing and ongoing administrative processes that are imposed on them. While it is an uncommon occurrence, these errors can even lead to the immediate disbanding of the organization.

Swyft can help!

With the help of these quick summaries of the pros and cons of the S corporation, you should be more prepared to decide if you should elect as an S corp. If you'd like to discuss your specific situation, the experienced business professionals at Swyft are here to help.Contact us today!