Before You Form an S Corp, Consider These Points

Our legal expert breaks down the pros and cons of forming an S Corporation.

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By Lori Hoberman

Opinions expressed by Entrepreneur contributors are their own.

Q: Someone told me that having an S corp has many advantages as well as disadvantages. Can you explain to me exactly what this type of corporation entails and if it is beneficial?
- Peggy Stiles

A: An S Corporation is a small corporation that elects to be taxed under Subchapter S of the Internal Revenue Code, which gives an electing corporation some, but not all, of the tax benefits of a partnership. An LLC can also make this election, enabling it to take advantage of the payroll tax savings discussed below. But before we get into the pros and cons, here is a brief history of the Subchapter S Corp.

Related: Choose Your Business Structure

Subchapter S Corporations were originally designed to bridge the gap for small, domestic corporations between corporate form, which ensured no member had liability but had two levels of taxation, and partnership form, which offered a much more efficient tax structure but required at least one member have full liability exposure. While these entities have been around a long time, they are less common today due to the LLC entity creation.

Benefits of Subchapter S:

Single level of tax: Unlike a regular corporation, which pays taxes on its income, there is generally no double taxation in a Subchapter S Corporation: All income and losses are passed directly to the shareholders.

Related: Business Structure Basics

Savings on payroll taxes: An S corporation shareholder who is actively engaged in the corporation's business wears two hats: owner and employee. The corporation must withhold and pay social security and Medicare taxes on its employees for tax purposes, however, distributions to shareholders are not subject to those taxes. Thus, the more revenue received by an employee/shareholder in her capacity as a shareholder, the less Medicare and social security taxes. As you might imagine, the IRS is scrutinizing this salary/distribution allocation very carefully given the potential for exploitation. If you are considering such an allocation, it is important to make sure that the salary portion is reasonable, relative to distributions, given the position and industry.

Disadvantages of Subchapter S:

As you grow beyond a small business, it might be tough to stay within the strict Subchapter S regime. You must:

  • Be a domestic corporation
  • Not have more than 100 shareholders
  • Only have domestic individuals and certain qualifying trusts as shareholders
  • Have only one class of stock

If you fail to satisfy any of these requirements at any time, you will void the Subchapter S election, and you will revert to the much less favorable tax regime of a regular corporation.

Why not just go with an LLC?

An LLC (as we discussed in my last installment) is the most flexible, tax-efficient business entity. While a Subchapter S corporation provides the same general flow- through tax treatment, an LLC is better where debt is involved and is much more flexible, with no restrictions on shareholders or equity classes.

So, why not just form an LLC? Well, it can be more expensive to form. Some jurisdictions, like New York, require publication in local periodicals of notice of formation for many weeks. An LLC operating agreement (tantamount to a shareholders agreement for a corporation) can be a bit more complex. Also, many people are more familiar with a simple corporate structure.

How to decide…

If you intend for your business to remain small for the foreseeable future with only U.S. individual shareholders, and you don't intend to borrow money, the Subchapter S might be for you. Even if you grow and take on outside capital, you can always void the Subchapter S election and end up as a regular corporation. But, if you believe you will not satisfy one of the requirements listed above in the foreseeable future, you expect to take on debt or intend to create a preferred class of equity for investors, go with the LLC.

Related: How--and Why--to Incorporate Your Business

Lori Hoberman

Entrepreneur and Attorney

Lori S. Hoberman is a New York City-based attorney and founder of law firm Hoberman Law Group.

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