Advantage and Disadvantage of S Corporation

Especially for new business owners, making sense of the advantage and disadvantage of S corporation status can tough. Sure, you know that many businesses operate as S corporations. But you also know or sense that an S corporation burdens you and your accountant with extra work and expense.

Accordingly, in the paragraphs that follow, I summarize the most significant “advantage and disadvantage of S corporation” issues for small businesses:

Note: An S corporation is also popularly known as an S corp, Scorp, Sub S corporation, or Subchapter S corporation. All of these names, or “nicknames,” indicate that a corporation had made an election with the Internal Revenue Service to be taxed according to Subchapter S of the Internal Revenue Code.

Disadvantages of an S Corporation

S Corporations present their owners and managers with several drawbacks or disadvantages, including the following:

S Corporation Accounting:

To the sole proprietorship who’s considering an S corporation, the S corporation choice may require more or better bookkeeping and accounting. An S corporation, for example, would often be required to prepare and submit balance sheets as part of its tax return.

This “extra accounting” disadvantage means that either you’ll need to learn more accounting or you’ll need to pay a bookkeeper or accountant to do the accounting. You’ll also, as a practical matter, need to buy a copy of an accounting software program like QuickBooks.

S Corporation Tax Returns:

As compared to a sole proprietor, S corporation tax returns cost more 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.

Even if you’ve been able to prepare your own sole proprietorship tax returns by hand or by using something like TurboTax, you may not want to prepare S corporation tax returns yourself. In my opinion, you shouldn’t prepare a corporate tax return yourself. The corporate return is just too complicated for a non-accountant.

S Corporation Shareholder Payroll Processing:

For one person businesses, an S corporation may force the firm to “do payroll.” In other words, even if the proprietor is the only person working in the business, the business will need to make the owner an employee and begin paying the owner-employer a reasonable wage. Treating an owner as an owner-employee means the business needs to file additional quarterly and annual payroll tax returns.

If a business already employs workers, the extra headache of adding one more employee, the owner, usually isn’t significant. But adding that first employee—even if the employee is the owner—creates a bunch of work.

Increased Accounting, Banking and Legal Costs of S Corporation:

A quick point: A corporation may have extra banking and legal costs as compared to a sole proprietor. For example, banks may charge more for their services. The firm may more frequently require the services of a good attorney. And state governments, their agencies, and even other outside parties may require a business that’s setup as a corporation to jump through additional legal or accounting hoops or to pay more in fees and taxes simply and only because of the corporate form.

To get a contractor’s business license in Arkansas, for example, a corporation must supply CPA-audited financial statements, but a sole proprietor doesn’t have to.

A number of states make a corporation pay significant extra fees or taxes that a sole proprietor doesn’t have to pay. California, for example, may require an annual franchise fee of several hundred or even several thousand dollars a year. Massachusetts may levy an extra tax on S corporations once the corporation reaches a specified size.

Loss of Self-employed Health Insurance Deduction for One-person S Corporations

While a sole proprietor can usually easily get the self-employed health insurance deduction—all the proprietor has to do is buy an insurance in his or her name--one-person S corporations will usually have difficulty getting the deduction. Here’s the short explanation for this: To get the deduction for self-employed health insurance in an S corporation, the health insurance must be a group plan purchased by the S corporation. But group plans typically aren’t sold to one-person groups.

This loss of the self-employed health insurance deduction can mean a tax increase of from several hundred dollars a year up to two to three thousand dollars a year.

S Corporation Ownership Restrictions:

Another important disadvantage of an S corporation concerns an S corporation’s ownership.

In an S corporation, all the owners need to be U.S. citizens or permanent residents. In addition, in an S corporation, the corporation’s profits need to be allocated and distributions to shareholders need to made purely on the basis of the ownership percentages. Finally, in an S corporation, the number of owners is limited to 100 persons. (Families, by the way, can often be counted as a single shareholder for purposes of the not-more-than-100-shareholders limit.)

In comparison to a sole proprietorship, you should know that pretty much anyone can own or operate a sole proprietorship. In other words, you don’t need to be a U.S. citizen or permanent resident to operate a sole proprietorship in the U.S. (Of course, resident and nonresident aliens do need to comply with immigration laws.)

And in comparison to a partnership, you should know that partnerships aren’t limited to a specified number of partners or specified types of partners. Furthermore, a partnership can allocate profits and distribute money and property to its owners in almost whatever way it wants. (Note: A partnership profit-sharing formula can’t be used to merely to minimize taxes.)

More Costly Startup of S Corporation:

Typically, sole proprietorships and partnerships are easier and less expensive to start than corporations. For example, a sole proprietorship or partnership can be started without anything more formal than a decision or a handshake. Sometimes, in fact, people start sole proprietorships or partnership without even realizing they’ve done so!

Furthermore, a sole proprietorship and partnership can almost always be started without any adverse tax consequence. And a partnership can add partners almost always without any tax cost.

In comparison, in order for a new or existing business to incorporate, the business needs to file articles of incorporation, articles of organization, or articles of formation with the state in order to start “existing.” Furthermore, the requirements of Section 351 of the Internal Revenue Code need to be met so that the incorporation isn’t viewed by the tax laws as the sole proprietor or partners exchanging the assets of the business for stock in a new corporation.

In a nutshell, the Section 351 requirements boil down to the rule that the people incorporating a business must control at least 80% of the corporation’s stock after the incorporation if they want to defer recognizing gain.

A sole proprietor who incorporates his or her business and who thereafter remains the business’s only shareholder should not have to worry about Section 351. But the logic of Section 351 should be kept in mind. If someone transacts business with a corporation in a way that creates profit to the shareholder, that profit can easily be taxed. If incorporating, for example, a business owner foists off a bunch of debt or personal debt onto the new corporation, that liability relief may create tax liability.

More Costly Termination of S Corporation:

One final important point should be made about the disadvantages of an S corporation. A corporation including an S corporation 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 (called a C corporation, by the way.) But you can still find yourself paying taxes at the liquidation of an S corporation. And here’s why: 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, merely winding up 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.)

Advantages of an S Corporation

The preceding list of S Corporation disadvantages may make you think that an S corporation makes no sense for your particular situation. But if you own an active trade or business that makes a profit in excess of what amounts to a fair salary to owners, an S corporation can save thousands of dollars a year in taxes. But before I discuss those tax saving advantages, let me point out a couple of the more general advantages of operating your business as an S corporation.

S Corporation Limited Liability

As compared to a sole proprietorship or a general partnership, an S corporation should limit your business liability.

In fact, as with regular corporations and also as with limited liability companies, an S corporation should reduce risk to the business’s owners. The general rule is that a corporation’s shareholders are not liable for the corporation’s debts merely because of their ownership. (Note that this same rule is also true of a limited liability company’s owners, who are called members.)

Tax Accounting Easier for S Corporations than for LLCs

An advantage of an S corporation compared to a partnership or an LLC that’s being treated as a partnership is that the tax accounting should usually be easier for an S corporation than for a partnership.

Partnerships complicate tax accounting in ways that are beyond the scope of this short article. But just to give you an idea of the sorts of problems they create, a partnership in effect requires that another set of bookkeeping records be kept--records in addition to the regular books kept for tax accounting.

Advantages of S Corporation Disadvantages

Let me make this perhaps obvious point: Some of the factors that in earlier paragraphs I describe as disadvantages of an S corporation aren’t really disadvantages once a business reaches a certain size or complexity.

For example, after a business’s financial affairs get complicated, you need good accounting even if the good accounting costs you more money. After a business begins to pay significant income tax bills, you should save money by using good accountants and attorneys even if those professionals charge high fees. If you’re already doing payroll for other employees, adding owners to the payroll doesn’t increase bookkeeping headaches much at all.

Accordingly, some of the factors that I list above as disadvantages of a S corporation are disadvantages only for very small S corporations—say S corporations with less than $50,000 in annual profits or S corporations with only a single owner-employee.

S Corporation Income Taxes:

As compared to a regular, C corporation, an S corporation saves corporate income taxes. How this saving occurs, though, is a little tricky. So let me explain.

If a regular corporation makes $100,000, the corporation pays corporate income taxes on that profit. If the leftover, after-tax profit is paid to shareholders as dividend, the shareholders pay personal income tax on the dividend.

In the case here, for example, the corporation might pay $20,000 of corporate income taxes on its $100,000 of profit (leaving $80,000 for dividends). And then the shareholder might pay another $15,000 of personal income taxes on its $80,000 of dividends.

In comparison, if an S corporation makes $100,000 in profit, the corporation pays no corporate income taxes on the profit. Rather, the profit is allocated to s corporation shareholders based on their ownership percentages. While the shareholders might pay $25,000 in personal income taxes on their profit—this is probably a good guess—they won’t pay any income tax on the dividend (or what’s actually called a distribution) when it’s made.

In this simple example, in other words, the shareholders pay do pay $25,000 of personal income taxes rather than $15,000 because of the S corporation. But the corporation doesn’t have to pay the $20,000 of corporate income taxes.

An S corporation, therefore, means that the owners avoid a second, double tax. And avoiding the second, double tax means of course, that as compared to a C corporation, an S corporation often saves business owners a substantial amount of income tax.

Note: You really have to work out with an accountant what the precise overall income tax savings are when comparing C corporations with S corporations. The savings amount depends greatly on the corporate and personal tax rates. Actual savings would probably be more if the corporate profits are very high and less if the corporate profits or shareholder incomes are very low.

S Corporation Payroll Tax Savings:

S corporations also offer another tax savings opportunity as compared to sole proprietorships, partnerships and C corporations that don’t pay income taxes because owners extract all of the profit in the form of salary: S corporations allow shareholder employees to save on payroll taxes.

To understand how the payroll tax savings work, you need to understand two things: (1) how payroll taxes get calculated, and (2) when payroll taxes get levied.

I’m going to be a bit general here, but payroll taxes basically include self-employment tax for sole proprietors and working partners in active trades or businesses and Social Security and Medicare taxes on employees, including shareholder employees.

The payroll tax rate is, roughly speaking, 15% on the first $100,000 of sole proprietorship profit, partner’s profit share, or shareholder salary and, 3% on anything above the first $100,000.

This means that someone who makes $100,000 a year as a sole proprietor, partner, or employee pays (either directly or indirectly) about $15,000 in payroll taxes.

And this means that someone who makes $200,000 a year as a sole proprietor, partner, or employee pays (again either directly or indirectly) about $18,000 in payroll taxes: $15,000 on the first $100,000 of income and $3,000 on the second $100,000 of income.

For an S corporation shareholder-employee, however, payroll taxes are only levied on the portion of the profit that the corporation calls “salary.” The corporation has to be reasonable in what it labels “salary,” but if $50,000 is a reasonable salary, then only the $50,000 is subject to payroll taxes. At a 15% tax rate, that means the S corporation shareholder pays roughly $7,500 in payroll taxes.

As compared to a sole proprietor, partner or C corporation employee making $100,000, therefore, the S corporation saves its owner $7,500 a year.

As compared to a sole proprietor, partner or C corporation employee making $200,000, therefore, the S corporation saves its owner $10,500 a year.

And, by the way, note that these amounts are savings per shareholder. If the example S corporation employs four shareholder-employees, the annual savings are roughly four times as much.

A caveat about my discussion of the payroll tax savings related to S corporations: I’ve been rough in my calculations and estimates. For example, the tax rate isn’t really 15% on the first $100,000, it’s really 15.3% on the first $97,500 in 2007 and 15.3% of some higher figure in years after that. What’s more, the tax rate on the earned income in excess of the 15.3% tax bracket isn’t taxed at 3% but actually rather only at 2.9%. Further, one other calculation complexity means that the tax bill isn’t quite as bad as I state here: Half of the payroll tax bill is a deduction for figuring income taxes and payroll taxes.

These factors don’t change the general payroll tax advantage of an S corporation, however: A S corporation can often save business owners substantial amounts of payroll tax if the business profit greatly exceeds what the business needs to pay owners for their work.