Top 10 S-Corporation Disadvantages [+ IRS Red Flags]

When setting up a new business, you have plenty of options. You can be a corporation, an LLC, or even a sole proprietor. But the #1 structure is typically an S-Corp. While this is a great structure, how much do you know about the S-Corp disadvantages?

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What is an S corporation?

It is basically the bread-and-butter entity for small businesses. The reason why it is so loved is it saves on self-employment taxes. The owner only has to pay employment taxes on a W-2 that the company issues. All remaining profits flow through and are taxed at the individual level.

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The entity structure has become very popular in recent years. You must file for 2553 to elect to be taxed as an S Corp.

You also have the option to revoke the election if desired. But remember to pay yourself a wage subject to employment taxes. Your W-2 must be based on reasonable compensation. IRS requirements drive this.

S-Corporations are popular because they offer several advantages over other types of business structures, such as Sole Proprietorships, Partnerships, and C-Corporations.

S-Corporations are taxed as pass-through entities, which means that the business itself is not subject to federal income tax. Instead, the business profits and losses are passed through to the individual shareholders, who report the income or loss on their personal income tax returns. This can result in lower overall tax liability for the business owners.

Like a C-Corporation, an S-Corporation provides limited liability protection to its owners. This means that the personal assets of the owners are generally protected from business debts and liabilities.

S-Corporations offer more flexibility than C-Corporations in terms of ownership, management, and profit sharing. For example, S-Corporations can have up to 100 shareholders, while C-Corporations can have an unlimited number of shareholders.

S-Corporation owners who work for the business can potentially reduce their self-employment taxes by taking a reasonable salary and receiving additional profits as distributions, rather than taking all profits as self-employment income.

These advantages make S-Corporations a popular choice for small and mid-sized businesses that want to minimize their tax liability, while still maintaining limited liability protection for their owners. However, it is important to carefully consider the potential disadvantages of S-Corporations, as well as the specific needs and goals of your business, before deciding on the most appropriate tax structure.

What are the disadvantages of being taxed as an S-corporation?

There are a few extra compliance headaches to be aware of. Not only do you have to pay a payroll service or do payroll yourself, you have an additional filing fee for Form 1120-S. Thankfully, this is also an information-only filing, and no tax is due. But filing penalties are high if you miss the filing deadline.

There is an added cost to file form 1120-S. This includes headaches in fees associated with paying a tax preparer to file it and the headaches of just one more thing on your to-do list.

Remember that while S corporations are tax efficient, they’re relatively inflexible. Income and distributions must be pro rata. You don’t have the flexibility of creating guaranteed payments or flexible distributions as you do with a partnership.

While there are several potential benefits to being taxed as an S-Corporation (S-Corp), there are also some potential disadvantages to consider. Here are some of the most common disadvantages:

Top 10 Disadvantages

While there are many advantages to being taxed as an S-Corporation, there are also some potential disadvantages. Here are some of the main disadvantages of being taxed as an S-Corporation:

  1. Restrictions on Shareholders: S-Corporations are limited in the number and type of shareholders they can have. For example, an S-Corporation cannot have over 100 shareholders; all shareholders must be U.S. citizens or resident aliens. This can make it challenging to raise capital and limit the business’s ability to grow.
  2. Increased Administrative Burden: S-Corporations are subject to more complex tax rules than Sole Proprietorships or Partnerships. This can increase administrative costs and a higher risk of making tax-related errors. S-Corps must comply with other administrative requirements, such as holding regular shareholder meetings, maintaining proper documentation and record-keeping, and filing annual reports with the state. These requirements can be time-consuming and may require additional resources.
  3. Higher Tax Preparation Costs: Because of the additional complexity of S-Corporation tax rules, the cost of preparing tax returns for an S-Corporation can be higher than for a Sole Proprietorship or Partnership.
  4. Pass-Through Income: While pass-through income can be an advantage, it can also be a disadvantage if the business is not profitable. S-Corp shareholders must pay tax on their share of the business income, even if they do not receive any actual distributions from the business. This can result in a tax liability for the shareholder even if the company is not generating any cash flow.
  5. Limits on Deductions: S-Corporation shareholders are limited in the deductions they can take on their personal income tax returns. For example, deductions for losses may be limited or suspended in certain circumstances.
  6. Strict Ownership and Distribution Rules: S-Corporations are subject to strict rules regarding the ownership and distribution of profits. For example, all shareholders must receive distributions in proportion to their ownership percentage, and there are limits on the ability to allocate profits and losses among shareholders.
  7. Limited Ability to Raise Capital: S-Corps may need help raising capital because they are limited to 100 shareholders and cannot issue different classes of stock. This can make it difficult for the business to attract investors or raise capital through public offerings.
  8. Payroll Requirement: Remember that you’re required to be on payroll. This means quarterly forms on 941, unemployment tax returns, and filing the W-2 at the end of the year. Again, a few more headaches for you and higher financial costs.
  9. Limited Shareholder Benefits: S-Corp shareholders are generally only eligible for the same benefits as business employees, such as health insurance or retirement plans, if they are also business employees. This can disadvantage owners who want to receive these benefits but want to be something other than employees.
  10. Limited Flexibility in Allocations: S-Corps have limited flexibility in allocating profits and losses among their shareholders. The allocation of profits and losses must generally be based on each shareholder’s ownership percentage, which can be disadvantageous if some shareholders have contributed more to the business than others.

It is crucial for business owners to carefully consider these potential disadvantages when deciding whether to elect S-Corp tax treatment. It is recommended to consult with a tax professional to fully understand the tax implications and requirements of being taxed as an S-Corp.

Final thoughts

Considering the potential disadvantages of being taxed as an S-Corporation is essential before deciding on the most appropriate tax structure for your business. It is recommended to consult with a tax professional to determine the best tax strategy for your specific circumstances.

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