S Corporation Disadvantage #4: Extra Startup and Termination Costs

S Corporation Disadvantage #4: Costs to Start and Stop

One final area of relative disadvantage needs to be considered by prospective S corporation business owners--the extra startup and termination costs.

Extra Costs for Starting an 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 partnerships 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 and then elect S status, the business needs to file articles of incorporation, articles of organization, or articles of formation with the state in order to start "existing."

A subchapter S election must be filed with the Internal Revenue Service and, in some cases, with the state's tax agency.

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.

Note: 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 by 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.

Extra Costs for Terminating of S Corporation:

A related disadvantage of an S corporation is that 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.)

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