The S corporation is more attractive to small-business owners than a standard (or C) corporation. That's because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there's just one level of federal tax to pay.
In addition, owners of S corporations who don't have inventory can use the cash method of accounting, which is simpler than the accrual method. Under this method, income is taxable when received and expenses are deductible when paid. Some relatively recent tax law changes brought about by the Small Business Job Protection Act of 1996 have made S corporations even more attractive for small-business owners. In the past, S corporations were limited to 35 shareholders. The 1996 law increased the number of shareholders to 75. Expanding the shareholder number makes it possible to have more investors and thus attract more capital, tax experts maintain.
S corporations do come with some downsides. For example, they're subject to many of the same requirements corporations must follow, and that means higher legal and tax service costs. They also must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions. The legal and accounting costs of setting up an S corporation are similar to those of a standard corporation.
Another major difference between a standard corporation and an S corporation is that S corporations can only issue common stock. Experts say this can hamper the company's ability to raise capital. In addition, unlike a standard corporation, S corporation stock can only be owned by individuals, estates and certain types of trusts. The 1996 Small Business Job Protection Act law also added tax-exempt organizations such as qualified pension plans to this list starting in January 1998. Tax experts believe this change should help provide S corporations with even greater access to capital because a number of pension plans are willing to invest in closely held small-business stock.