Costs and Drawbacks of an S Corporation: An Introduction
S corporations deliver a bunch of benefits to small businesses. No doubt about that.
But they also burden small businesses with extra costs. And they suffer from some drawbacks.
Accordingly, while you definitely should consider the Subchapter S option if you run a profitable small business, don’t jump into this before you’ve carefully considered the following S corporation costs and drawbacks:
S Corporation State Fees and Excise Taxes
First, you will have the cost to form and maintain the legal entity you use for your S corporation.
States charge you a filing fee to setup the corporation or LLC you use, for example. And some states (especially “blue” states) charge hundreds of dollars.
Further you will always pay the state an annual filing fee and possibly annual excise taxes or franchise taxes. That usually means at least $100 a year. And sometimes—such as in the case of businesses operating in California—way, way more than that.
Tip: We’ve got a pretty good article on California S corporation costs over at our blog: Do California S Corporations Really Save Taxes?
Small S Corporation Tax Return Preparation Costs
A second category of new costs you’ll shoulder? You’re going to have several new tax returns you need to deal with if you start running your small business as a Subchapter S corporation.
For example, as a practical matter, you’re going to have to pay a tax accountant to file the annual 1120S S corporation tax return as well as any equivalent state corporate tax returns. A rough guess? Your tax accountant will probably want at least a grand… and maybe even a lot more than that if you’re in a high cost of living area.
And this related comment: You really will need to operate a decent, orthodox accounting system if you want to run your business as an S corporation. The corporate tax returns basically force you to do that since the returns require information that only comes out of a “real” accounting system… like balance sheet information.
Finally, you’re also going to need to pay the owners (so the proprietor and the partners) regular employee payroll. And that may be a new cost if you’ve previously skirted doing payroll and preparing payroll tax returns because you haven’t had to “have” employees. Another rough guess at costs? Outsourced payroll solutions easily run $500 a year and sometimes double that amount—even if you have a single employee.
Note: Putting owners on the payroll may also trigger new payroll taxes that a sole proprietor or partner don’t get hit with. For example, the Federal Unemployment Tax and then any state-level unemployment taxes.
Other Miscellaneous Operating Cost Bumps
Incorporating a small sole proprietorship or partnership also sometimes burdens a small business with surprising new costs, too.
Let me just give you two examples so you’ll know the sort of things to watch for and the areas you may need to do a little bit of additional research in:
Insurance: Operating as a corporation or LLC (which you will do because that corporation or LLC is the “thing” you turn into an S corporation) can trigger additional insurance costs. In Washington state, for example, state law requires professionals operating as a corporation or LLC to have a high minimum amount of malpractice insurance—which means these small businesses often buy more insurance once they’re an S corporation. Moreover, sometimes, just operating as a corporation or LLC means you pay more for the exact same insurance such as for autos. These costs can add up to many hundreds of dollars or even thousands in a worst case scenario.
Accounting: Some states create extra business accounting requirements for businesses that operate as something other than a sole proprietorship or partnership. The state of Oklahoma, for example, doesn’t require a sole proprietor operating a construction company to have a CPA review or audit the business’s financial statements. But the state does require a corporation to get such a review or audit. (This sort of requirement, by the way, probably destroys the tax incentives to incorporate.)
Restrictions on Types of Owners
Let me also mention a couple of more general drawbacks, starting with the restrictions on S corporation shareholders.
Tax law basically says only US citizens and permanent residents (and then owners that closely resemble US citizens and permanent residents such as testamentary trusts and bankruptcy estates) can own shares in an S corporation.
Note: I’ve got a longer discussion of on this subject here: Who Can Be an S Corporation Shareholder?
But the point is, you need to think ahead about whether this sort of restriction on owners creates a problem.
Restrictions on Classes of Stock
Another restriction? You can have both voting and nonvoting stock. And you can have shareholders own different percentages of the company.
But those “differences” are about the only tweaks you can make to the stock shareholders own.
You cannot, for example, give certain shareholders a preferred dividend or protection against dilution.
Your allocations of profits to shareholders and the distributions you make to shareholders can only be based on ownership percentages.
Suppose, for example, that you and I together own an S corporation. Further, suppose that you own 60% and I own 40%. That means you get 60% of the profits and of the distributions, no matter what. And that I get 40% of the profits and distributions, no matter what.
Note: An S corporation can pay shareholder-employees different salaries. For example, if you work in the imaginary S corporation we together own but I’m retired, the S corporation can pay you a salary but then pay me zero salary
Final Words on S Corporation Costs and Drawbacks
So what do these costs and drawbacks mean? Do they mean you should just drop this crazy idea of being an S corporation?
I don’t think so. Or at least not yet.
What I do think is you need to come up with a rough idea about the extra costs an S corporation will burden you with. Then you need to come up with a rough idea about the tax savings an S corporation will deliver. And after that you need to make sure you’re really getting a good deal.
I would not be surprised, for example, if on average an S corporation adds a couple of thousand dollars of cost annually to a small business’s operating costs.
And what I’d say is that you want to saving some multiple of this cost in order to justify the S corporation decision. For example, if an S corporation does cost you $2,000 a year, I think you want to be saving at least $6,000 or $8,000 annually. And if you can save more like $10,000 or $12,000 a year in payroll taxes, well, that’s really when the choice makes most sense.
Additional Information You May Find Useful
If you want additional information about how to maximize the tax savings related to running a business or investment venture, you may also be interested in one of our downloadable e-books (see descriptions below). Each book covers a category of tax planning topics that easily save a business owner significant amounts of income or self-employment taxes (potentially thousands of dollars a year) and is instantly downloadable.
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