S corporation advantages and disadvantages
/What is an S Corporation?
An S corporation is a corporate entity that passes its income through to its owners, so that the entity itself does not pay income taxes. The owners report the income on their tax returns, thereby avoiding the double taxation that arises in a regular "C" corporation. In effect, an S corporation entitles shareholders to the protections of incorporation while avoiding double taxation.
Advantages of Using an S Corporation
When starting up a business, should you set it up as an S corporation? There are many advantages to doing so, but you must be aware of several issues with it, as well. First, consider the following advantages of an S corporation:
Shareholder protection. As is the case with any corporation, an S corporation shields its shareholders from the debts of the corporation. Thus, if the corporation takes on debts and then is unable to pay them back, its shareholders cannot be held liable for them.
Distribute appreciated property. A distribution of appreciated property by an S corporation to its shareholders generates a gain in the amount of the difference between the corporation’s basis in the asset and its fair market value. This gain increases the basis of the shareholders’ stock in the corporation.
Distributions are free of payroll taxes. Any distributions made from an S corporation to shareholders are not subject to payroll taxes. This means that social security, unemployment, and Medicare taxes are not paid on these distributions.
Double taxation circumvention. The earnings of an S corporation are only taxed once, at the level of its shareholders. This is significantly better than for a C corporation, where the corporation is taxed and then again when any distributions to shareholders are taxed.
No accumulated earnings tax. An S corporation is not subject to the accumulated earnings tax, which applies to a C corporation if it accumulates an excessive amount of earnings without paying some portion of it to shareholders.
Passive loss offsets. If a shareholder does not actively participate in managing the business, any income passed through from it is characterized as passive, and so can be used to offset passive losses.
Single taxation level on sale of business. When an S corporation is sold, the shareholders will pay tax on the distribution. This is better than for a C corporation, where tax is paid by the corporation and again by the shareholders when the proceeds are forwarded to them.
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Disadvantages of Using an S Corporation
Despite these advantages, converting from a C corporation to an S corporation does not always make sense – or it at least requires consideration of certain issues. In particular, the following concerns may be present:
Minimal cash retention. It is difficult for an S corporation to build up cash reserves, since its shareholders need distributions in order to pay taxes on the income that has been passed through to them.
Net operating loss carryforwards. It is not allowable to carry forward net operating losses (NOLs) from a C corporation to an S corporation, which can be a significant concern when an NOL is quite large.
Taxable built-in gains. A tax is imposed if an S corporation sells or distributes to its shareholders any assets that appreciated in value before the firm converted to an S corporation. The tax applies to any asset sales or distributions that arose during the five years prior to the date of the conversion to an S corporation.
Tax-free fringe benefits. Some tax-free fringe benefits (such as accident and health insurance premiums) are not available to the shareholders in an S corporation that hold more than a 2% interest in the business. When an S corporation pays for these benefits, they are treated as wages, which means that payroll taxes will be applied to them.
Unplanned termination. A dissident shareholder can trigger the termination of the entity’s S status by transferring shares to an entity that is not allowed to be a shareholder, such as a nonresident alien.