An S corporation is a special type of corporation that draws its designation from Subsection S of the tax code. To start an S corporation, a small business owner starts a C corporation, then files for S corporation status with the IRS. While an S corporation is similar to a C corporation in many respects, it has very different income and self-employment tax regulations.
Advantages of Starting an S Corporation
- Limited Liability - Like in most corporate structures, the owners of an S corporation have only limited liability for the actions of the company, so they can't be held responsible for its actions or debts unless they have signed a personal guarantee.
- Pass Through Taxation - Similar to an LLC, an S corporation does not pay taxes at the corporate level. Any income or losses are reported only on the personal income taxes of its owners - avoiding the issue of double taxation that affects C corporations.
- Self-Employment Taxes - Because the owners of an S corporation are considered employees of the company, they aren't subject to self-employment taxes like the members of an LLC.
- Perpetual - Unlike an LLC, S corporations have an unlimited life span. The company will continue to exist if its owner leaves, and can generally continue operating without too much disturbance.
- Easy Transfer of Ownership - The ownership of an S corporation is easily transferred through the sale of company stock.
- Reduced Taxable Gains - The S corporation can also be attractive to owners who anticipate selling their company at some point. When the company is sold, an owner's taxable gains from that sale can be less than they would have been for a traditional C corporation.
- Easy to Convert - If, as a company grows, it feels that a C corporation would be a better choice, it can drop its S corporation status with the IRS.
Disadvantages of Starting an S Corporation
- Less Attractive to Investors - Like an LLC, S corporations are less attractive to outside investors because of their pass-through taxation laws. S corporation owners may need to convert the business into a C corporation before working with angel investors or venture capitalists.
- Record-keeping Requirements - Like a C corporation, an S corporation is required to have regular meetings, create bylaws and keep company minutes, which can take up a significant amount of time. If an S corporation fails to keep up with any of its requirements, it loses its S corporation status and is treated like a C corporation.
- Membership Limitations - An S corporation has strict membership limitations. Stockholders in the company must be U.S. citizens, and can't include any corporations, LLCs, partnerships or trusts. S corporations also have a maximum of 100 different stockholders.
- Stock Classification Restrictions - Forming a company in an S corporation format also means that the business can only issue one kind of stock. The inability to issue "preferred" stock can sometimes give the original owners less control over the company than they would like.
- Limited Personal Liability
- Perpetual Existence
- Better Fringe Benefits
- Pass-Through Taxation
- More extensive record keeping requirements
- Restrictions on number and type of allowable shareholders
- Additional Restrictions