Entrepreneurs often struggle with how to structure their business. My clients often pose this question to me, as they should, while trying to make sense of the advantages and disadvantages of each corporate structure.
Essentially, the most simplest structure is to be a Sole Proprietor. But it is also the most risky and can be the most costly with respect to paying higher taxes if your business is profitable. Therefore, to protect yourself and limit your liability to only your business assets, the next step to take would be to register your company as an LLC. This will also give you various options on how to structure your business for tax purposes – Partnership, Corporation, or S Corp, or maintain your sole proprietor structure for federal if you are the only member of the LLC.
One of the most popular business structures many Entrepreneurs are embarking on is the S Corporation. Therefore, I have created a blog describing the Advantages and Disadvantages for this particular structure to give a basic overview that your fellow Entrepreneurs, and CPA, are referring to when they refer to the S Corp election they made for their business, or are recommending you make for yours.
Listed below are the advantages and disadvantages of an S Corp.
- Extra Tax Accounting –
Deciding to make the S Corp election may require more or better bookkeeping and accounting. And this “extra accounting” means that you will either need to learn more accounting or hire a bookkeeper or accountant to do it. You may also, as a practical matter, need to buy a copy of an accounting software program like QuickBooks.
Unlike a sole proprietor, the S Corp requires an extra tax return to be filed, that can add to your tax preparation fees. These tax returns are also more costly to prepare. Partly, the extra cost stems from the increased complexity of a corporate return. And partly, the extra cost stems from the fact that a corporate return is typically many more pages than a simple sole proprietorship tax return. An S Corp, for example, would often be required to prepare and submit balance sheets as part of its tax return.
Although this is listed as a disadvantage, you can never go wrong with a better accounting for the activity of your business. Every Entrepreneur should know their numbers and where they are going. Therefore, this disadvantage can very well be seen as an advantage with plenty of opportunity.
- Ownership Restrictions –
An S Corp limits the type of shareholders allowed, the number of shareholders, and the type of ownership interest shareholders may have.
For example, all the owners (shareholders) of an S Corp need to be U.S. citizens or permanent residents, and cannot be partnerships or trusts. And the corporation’s profits need to be allocated to shareholders on the basis of the ownership percentages.
The S Corp may have only one “class” of stock and are not allowed to have preferred stock But you can have non-voting stock.
Finally, in an S Corp, the number of owners is limited to 100 persons. Families, however, can often be counted as a single shareholder for purposes of the not-more-than-100-shareholders limit.
- Extra Costs to Start and Stop –
An S Corp often can’t be liquidated without paying some federal and state income taxes. This problem of “taxes due at corporate termination” is a bigger worry with a regular, non-S corporation (i.e. C corporation). But you can still find yourself paying taxes at the liquidation of an S corporation.
How this happens is when a corporation liquidates, the corporation distributes property to its shareholders. If a particular item of property has a fair market value in excess of its depreciated cost, the difference between the fair market value and the depreciated cost gets recognized as either a gain or loss.
In comparison, with property in a sole proprietorship or partnership, when that property is distributed in a liquidating distribution situation, the proprietorship’s or partnership’s operation doesn’t necessarily create gains or losses, even if the sole proprietorship or partnership distributes appreciated property to the owner or owners. (Note that converting business property or investment property to personal-use property may trigger tax.)
- Limited Liability –
Compared to a sole proprietorship or a general partnership, an S Corp will limit your business liability because to create an S corporation you will first have to form an LLC or a corporation.
An S Corp, therefore, will reduce the risks the sole proprietors bear. The shareholders are not personally liable for the corporation’s debts merely because of their ownership of the business. This same rule is also applies to LLC owners, who are called “members.”
- Corporate Income Tax Savings (i.e. No Double Taxation) –
Compared to a regular C corporation, the S Corp does not have the double taxation issue on the issuance of dividends to its shareholders. First, because S Corps are considered flow-through companies for tax purposes, meaning the net income is allocated to its shareholders by a K-1, and then reported on the shareholder’s respected personal tax return, S Corps do not issue dividends to its shareholders. The S Corp simply distributes cash, and those distributions are generally not taxable to its shareholders because the shareholders have already been taxed on that income when it was allocated to them. Therefore, there is no double taxation on the income earned by the S Corp and then distributed to its shareholders.
- Payroll Tax Savings –
Compared to sole proprietorships and partnerships (general partners only), the biggest benefit of the S Corp structure, next to the limited liability benefit, is that the net income allocated to its shareholders is not subject to self-employment tax (or payroll tax) of 15.3%. .
Although the shareholders are required to pay themselves a salary under the S Corp structure, the amount of payroll taxes paid with that salary pales in comparison to the amount of self-employment tax that will be paid on the net income to the sole proprietor and general partner.
Because this can prove to be a significant benefit to the Entrepreneur looking at which corporate structure for their business, it is important to emphasize that there are a number of factors that should also be considered when making the decision to file an S Corp election due to the limitations on the number of shareholders, type of shareholders, and type of stock the S Corp is allowed to have.
For example, if you plan to look for many investors for your business, the S Corp structure may not be suitable. The investors you bring may want various type of payout agreements that are not available with the S Corp structure, and you may recruit more than 100 investors.
This is why it is very important to have a healthy relationship with your CPA and have an open, candid conversation with him/her on your plans with the business you are starting or working on. This doesn’t mean that once you choose a particular tax structure, that is the end all be all. But it can get expensive and time consuming to change the structure to one that is more suitable for your business if you choose the wrong one in the beginning.