Advantages and Disadvantages of an S Corp
An S Corporation (S Corp) is a business structure that combines the advantages of an LLC with some benefits of a C Corporation. An S Corp is a pass-through entity that limits the personal liability of the owners while providing tax benefits. Although there are some excellent advantages to forming an S Corp, there are still some key disadvantages that potential owners should consider.
Advantages of an S Corp
- Liability Protection: An S Corp provides its owners with the same limited liability protection as an LLC, preventing owners from losing personal assets in the event of a lawsuit or creditors going after the company.
- Tax Advantages: One of the major benefits of an S Corp is that, unlike a C Corp, it will not be taxed twice. An S Corp shares any profits or losses with the owners, and they only pay taxes on their personal returns.
- Free Transferability of Ownership: The ownership of an S Corp can be freely transferred without the company losing its status.
- Flexibility for Owners: An S Corp is more flexible than a C Corp when it comes to management structure and the sharing of profits because it has annual meetings and needs shareholder agreements.
Disadvantages of an S Corps
- Additional Annual Requirements: An S Corp requires more paperwork than an LLC, which includes holding annual meetings and keeping detailed records.
- Strict Ownership Limitations: An S Corp is limited to one class of stock, and there is a cap on the maximum number of shareholders. The number of shareholders cannot exceed 100, and all of the shareholders must be US citizens.
- High Cost of Formation and Dissolution: The cost of forming an S Corp can be more expensive compared to LLCs because of the additional paperwork that is necessary.
- Difficult to Qualify For: Not all states allow for the creation of an S Corp, and some states impose restrictions on businesses that want to form an S Corp.
Steps to Form an S Corp
Forming an S Corp can be an involved process that requires extensive documentation. The first step is to decide if forming an S Corp is the right choice for your business. Here are the steps you will need to take in order to form an S Corp:
- Choose a Business Name: You need to choose a business name and register it with the state where you plan to do business. You will also need to check if the name is available on the internet and make sure it is compliant with state and federal regulations.
- Form Articles of Incorporation: You must create Articles of Incorporation that contain specific information about your business including its name, its purpose, the type of business, the address of its headquarters, and the members of its board of directors.
- File an S Corporation Election: Once you have completed the Articles of Incorporation, you need to file for S Corporation status with the IRS by filing an S Corporation Election. You will need to include the Articles of Incorporation, a copy of your company’s formation documents, the election of S Corporation status, and the fee for filing.
- Create a Shareholder Agreement: This is an agreement that outlines the rights and responsibilities of the shareholders of the company. This agreement should be signed by all the shareholders of the company.
- Obtain Necessary Licenses and Permits: Depending on the type of business you are starting, you may need to obtain various licenses and permits from the local, state, and federal governments.
- Hold an Initial Meeting of Shareholders: This is a meeting of the shareholders of the company, where important decisions regarding the company and its officers will be made.
Tax Implications of an S Corp
An S Corp has several advantages from a tax perspective. One major benefit of an S Corp is the potential to reduce self-employment taxes. With an S Corp, profits that would previously be subject to self-employment taxes can now be classified as non-employee compensation and only subject to income tax.
Another great tax advantage of an S Corp is that it enables the owners to pass through business losses to their personal returns. This is beneficial because it allows the owners to save on taxes by deducting the losses from their other income.
It is important to note that while an S Corp can provide various tax benefits, the company is still responsible for Federal, state, and local taxes. Be sure to consult a qualified accountant before making any tax decisions.