The Pros & Cons of S-Corporation Status
If the number of shareholders in your corporation is small, you may think that becoming an S-Corporation is the right move, but you should weigh the advantages and disadvantages first.
Advantages of S-Corporation Status
One of the main advantages of S-Corporation status is that it avoids the double taxation that occurs with a regular C-Corporation. In a C-corporation, the corporation pays income tax on its profits and, if those profits are distributed to shareholders, the shareholders pay income tax on the distribution.
Electing S-Corporation status passes the income or losses of the corporation to the shareholders who recognize the income or loss on their personal tax returns. This is an advantage if the corporation expects to show a loss at first. The loss can be used to offset the shareholder’s income from other sources, including a spouse’s income.
Disadvantages of S-Corporation Status
Passing income through to shareholders can be a disadvantage in some instances. If the business is profitable, shareholders will be required to pay income tax on their share of the profits, even if that money is not distributed to them. In a C-Corporation, profits can be used to expand the business and shareholders are not required to pay taxes until distributions are made.
Reasonable salaries paid to employees are deductible business expenses for S-Corporations as well as for C-corporations. However, in an S-Corporation, fringe benefits may not be deductible as they would be in a C-Corporation.
Even though losses pass through to shareholders in an S-Corporation, those losses aren’t deductible by shareholders who don’t materially participate in the business. This could result in higher taxes overall.
Not every corporation qualifies for S-Corporation status. In order to elect S-Corporation status, the corporation can only have one class of stock. The corporation can have no more than 35 shareholders, although a husband and wife who both own shares will only be counted as one shareholder. No shareholder can be a nonresident alien or another corporation. All of the shareholders must consent to elect S-Corporation status. The corporation also cannot earn too much income from investments.