Why the S Corporation might not be the right legal business structure for your startup

If you’re launching a business, you’ll inevitably encounter the tough decision of picking a legal business structure. It’s a significant issue, one you’ll want to consider carefully from all angles and potentially discuss with a tax advisor or accountant.

The S Corporation has become one of the most popular business structures in the U.S. thanks to its favorable ‘pass through’ tax treatment. And while it’s an advantageous way for small businesses to optimize their taxes, the S Corp isn’t right for every business. With the S Corp election deadline approaching on March 15, it’s a good time to examine this business entity and determine if it’s the right structure for you.

What is an S Corporation?

An S Corporation begins as a general, for-profit C Corporation. After the corporation has been formed, the business can elect ‘S Corporation Status’ by filing Form 2553 with the IRS in a timely manner. With this election, the company is now taxed as a sole proprietor or partnership rather than as a separate entity like the C Corp.

A C Corporation files its own tax form and has its own tax rates (C Corp tax rates). If the company makes a profit, it can choose to retain the earnings in the company as part of its operating capital or distribute the profits as dividends to shareholders. With a C Corporation, these dividends are essentially taxed twice: first at the corporate level when the company files its taxes and then at the individual level with each shareholder’s 1040 form.

By contrast, the S Corporation is not subject to corporate tax rates. Its profits and losses are passed through and reported on the personal income tax returns of the shareholders. That’s why the S Corp is known as a ‘pass-through entity’ and avoids this double taxation of dividends.

Of course, bear in mind if a shareholder also works in the business, they must be paid a reasonable wage for their activities. And these wages are subject to the personal income tax rate (in other words, you can’t just compensate yourself in dividends).

Disadvantages of the S Corp

While this pass-through tax treatment can certainly be advantageous, the S Corp isn’t for everyone. If you’re trying to choose a business structure, here are several circumstances where the S Corporation might not be the right choice:

1. You’re a sole proprietor who doesn’t want the hassle: The S Corporation entails extra structure, formalities, and compliance obligations for the solo entrepreneur with a “payroll of one.” If you incorporate as an S Corporation, you need to set up a board of directors, file annual reports and other business filings, hold shareholder’s meetings, keep records of your meeting minutes, and generally operate at a higher level of regulatory compliance than your business might need or want to deal with.

You also will need to do payroll to pay your employees, even if you’re the only employee. This can create extra costs and operational challenges. Instead of dealing with all this red tape and complexity, forming an LLC (Limited Liability Company) might give you greater simplicity and ease of doing business. With an LLC, as a sole proprietor you don’t have to create a board of directors or jump through as many regulatory hoops. And, the LLC still gives you the pass-through tax treatment just like the S Corp.

2. You want flexibility in how you distribute profits (dividends) among shareholders: The other downside of the S Corp is its strict allocation of income. In an S Corporation, each owner/shareholder must share in the income in direct proportion to their ownership.

What does this mean? Let’s say you start a business with three colleagues, each owning 25% of the business. You do the bulk of the work in Year 1, your company makes a big profit, and everyone decides that you should take home 50% of the extra profit. Since income and loss are strictly based on the pro-rata share of ownership in an S Corp, this isn’t possible (at least in terms of personal income tax reporting). Each owner will be taxed on 25% of the profits, regardless of any other agreement. In contrast, an LLC offers more flexibility when it comes to allocating income amongst the owners.

3. You plan to reinvest any profits back into the company: As profits pass through entities, individual owners of an S Corporation or LLC are liable for any taxes owed on profits — whether that money is retained in the company or put in their wallet.

For example, if you own 50% of an S Corporation (or LLC for that matter) and that company makes $50,000 in profit, you need to report $25,000 in income on your personal tax return. It doesn’t matter whether that $25,000 actually ended up in your pocket or you decided to keep it in the business in order to boost your marketing efforts next year. This is known as “phantom income” and can obviously cause a problem for some shareholders. If you plan on retaining money in the company, you should consider the C Corporation over both the LLC and S Corp.

4. You can’t qualify: Lastly, the IRS places certain restrictions on S-Corporations, including:

• An S-Corp cannot have more than 100 shareholders
• All shareholders in an S-Corp must be individuals (not LLCs or partnerships) and legal residents of the United States.

Your choice in business structure will ultimately depend on all the unique aspects of your business, financial situation, and short-term/long-term goals. Regardless of which business type you choose, taking a serious look at your legal structure is essential to set your business up for success.

Dmitriy Shironosov and STILLFX via shutterstock