S Corporation Disadvantages
While the majority of business owners choose an S Corporation for tax purposes, it is important to understand the S Corporation disadvantages that will affect small businesses. From strict ownership rules and IRS oversight to limited shareholders and higher administrative costs, these detriments may outweigh the benefits for some companies. Understanding the possible setbacks beforehand will allow small business owners to make better-informed choices as to whether or not an S Corp is an optimum format for their needs.
Just A Little About Business Entities:
A lot of the small business owners that I’ve been meeting lately seem to already know the business entity they want for their existing or startup company (mostly LLCs or S Corps). This knowledge is usually gained from the “grapevine” or through their own research – the grapevine being a friend and/or family member who also has a business and/or starting one and somehow decided to choose either and LLC or an S Corp and have decided to spread the good news.
The problem is that these “news spreaders” don’t know enough about business entities, and their many traps and nuances to give such advice. It is important to choose the right entity from the get go and, therefore, very important to get the advice of a tax professional such as a CPA, Enrolled Agent, or tax attorney.
The S Corporation IS indeed an excellent tax vehicle for small businesses, but it also has very stringent rules that must be followed as well as complex taxation rules that make it not ideal for certain small businesses so, let’s explore some of its DISadvantages:
1. Higher lower tax bracket than the C corporation.
C corporations are taxed at a lower tax bracket for the first 75K of income. This lower tax brackets is not available to S Corporations. This also doesn’t have that much effect on small business owners as most expect losses in their first few years, but for the tiny margin that will generate net income, this matters very much and can quickly create a downside to S Corporations.
2. Possible, maybe even easy, inadvertent loss of S corporation status.
Once the S Corporation veil is lost, the company is just a regular C Corporation. The primary way to lose the S status is to no longer meet the requirements for the S status. For instance, one of the qualifying rules is that a non-resident alien can’t be a shareholder, therefore, having a non-resident alien as a shareholder, among other things, would cause the loss of the S Status.
Now if you think “I don’t have to worry about that, I don’t have any non-resident alien shareholders”, but here’s the rub: if a shareholder-partner dies and transfers their interest to let’s say, a Canadian relative who qualifies as a non-resident alien, the S status would be forfeited, in other words, lost, then it would be just a regular C Corporation, and along with that come inevitable and costly higher complexities and taxes.
For instance, we just took on a high net worth client – let’s call him David – who is dealing with this very particular situation where his wife died and the business she owned passed on to David. Turns out that David isn’t a US citizen (his wife was), and S corporations have this rule – from the subchapter S of the Internal Revenue Code – that non-citizens can’t be owners of a S corporation or it will lose its S status. The company…and David…really just David…now owe a total of 500k in taxes.
If you are thinking it still doesn’t apply to you, but I want to emphasize that several other little things can trigger the loss of the S status due to the complexity of the rules surrounding the S Corp. As the ‘little things that can trigger loss of S status” is the focus of this article and therefore a quick summary being the point, a comprehensive address is beyond this scope of this article. In certain circumstances, you would need a deeper dive into your particular situation. If so you will need to consult a CPA. If you wish to talk to us, schedule a call with the button below.
3. Complex tax structures is another disadvantage.
Lastly, it definitely increases your cost of operations. If you are solo practitioner, you can file an LLC and be taxed as a Schedule C, ie individual on your personal, which means your tax forms don’t change that much, and is therefore, less costly to operate, but as an S Corporation, you’ll need to file a whole separate tax form (1120S)
4. Limits access to capital.
For certain small businesses, those who are growing, the disadvantages of their S Corporations come from the limits on the number of shareholders and the single class of stock rule. These can severely limit your access to capital as they would not be able to issue their stocks at larger numbers.
The above are by no means, comprehensive, nor do they describe the complete picture for each company. Please reach out to us for a free consultation to get more clarity on your particular situation and business entity. If, for any reason you want to rethink your S corporation, including because of this article, here are other worthy entities to explore:
- C corporation, as previously mentioned
- DBA, doing business as, taxed as an individual, (click here to get our DBA guide)
- LLC
- LLP
- LP
- General partnership
- Professional corporation
- Serial LLC
Also be sure to be on the look out for more articles.
We hope this article was helpful. Be sure to be on the look out for more articles. Got questions? Comments? Suggestions on topics that interest you? We would like to hear from you. Have you had such a situation like David’s yourself? Do you know someone who has? We want to know your experiences with S Corporations, whether just starting out, switching, you’ve been an S Corp all these years, or just researching…and the rainbows in between!
Disclaimer
Information contained in this article does not constitute a binding contract between the reader and the writer, nor does it constitute tax advice for the purposes of tax evasion. Again reach out to us about business entities particular to you to get the full picture.
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S Corporation Disadvantages FAQs❓
What are the main disadvantages of an S Corporation to small businesses?
Main S Corporation disadvantages are strict ownership rules, IRS oversight, limited shareholders, higher administrative charges, and complex taxation systems. These factors can overshadow benefits for certain small businesses.
Is it simple for an S Corporation to have its status revoked?
Yes. S Corporations inadvertently risk losing their status if they don’t meet IRS requirements, i.e., they have a non-resident alien shareholder. Losing S status makes the business a normal C Corporation, potentially resulting in higher taxation and issues.
In what way does an S Corporation affect access to capital?
S Corporations are bound by shareholder limit and single class of stock restriction, which may put investment capital out of reach vs. C Corporations.
Are S Corporations more expensive to operate than LLCs?
Too often, yes. S Corps require the preparation of a special tax return form (1120S) and adherence to complex tax rules, which may put accounting costs in excess of an LLC taxed as a Schedule C.
What should small business owners do before electing an S Corporation?
A tax attorney, CPA, or Enrolled Agent must be consulted to understand the entire implications of an S Corp. Consider reviewing other forms of entities like C Corporation, LLC, LLP, or DBA based on the purpose of the business.
