S Corporation: Pros and Cons
Deciding on a business entity type is one of the most important decisions for a business. It affects everything from tax status to ownership, to aspects of day-to-day operation to even how people perceive your business from the outside. And yet, it is a decision that many small business owners don’t make—or, rather, don’t realize they are making.
If you have started a business, then you also have a business structure. The question is whether that structure is one that you chose after considering all your options or if it is the default selection, made for you because you’ve never taken formal steps to choose an entity type.
There are many possible entity types. The most important to know are:
- Sole proprietorship
- General partnership
- LLC (Limited Liability Company)
- Corporation (C or S)
This article is an excerpt from our free, downloadable Incorporation Guide and will focus on the S Corporation. The S Corporation is a special type of corporation that avoids the double taxation problem of a C Corporation, but in exchange for other strict regulations. The S Corporation designation must be approved in writing by all shareholders, and filed with the state.
- Pass-through taxation. The profits from the S Corporation pass through to the shareholders with no corporate income tax. All taxes are paid at the individual level on the shareholders’ personal returns.
- Limited liability. S Corporations offer protection to their shareholders for the business’s debts and liabilities. Shareholders are only liable to the amount of their investment in the company; personal assets of shareholders are protected.
- Selling stock. S Corporations can sell shares of the company’s stock to raise capital. Because ownership is defined by shareholders, the business has unlimited life, continuing to exist and run no matter what happens to any individual owner, director, or even founder.
- Formation, maintenance, and compliance requirements. Unlike the simpler entity types, S Corporations must be created by the state, by filing a document known as either a Certificate of Incorporation or the Articles of Incorporation and paying a filing fee. The S Corporation differentiates itself from the C Corporation by also filing Form 2553 with the IRS electing the S Corporation designation. Each year the corporation must pay a fee to maintain its status, and file annual reports.There are also important compliance rules, including mandatory director and shareholder meetings, with rules about notification and documentation, corporate minutes requirements, and procedures for how shareholders, directors, and officers operate the company. If procedures are not followed, then the corporation runs the risk of piercing the corporate veil.
- Ownership restrictions. While the S Corporation can issue any number of shares of stock, divided any number of ways among the shareholders, there is a maximum of 100 total shareholders permitted by law. And those shareholders, 100 or fewer, must all be U.S. citizens or permanent residents of the United States. Estates and certain qualified trusts are also permitted; all others are excluded. And unlike C Corporations, S Corporations may only issue one class of stock.
Want to know more about an S Corporation or other business entity types? Download our free Incorporation Guide.