The S Corp: Pros and Cons

Your are about to start a business, and you heard that an SCorp is a business structure used by many small businesses.  However, you are not certain if it is the right structure for your business.  Below is a simple list of the Pros and Cons of an SCorp:

PROS:

1.  Provides the protection afforded shareholders of a corporation:  An S Corp is actually formed as a corporation and is governed by the state corporate law statute (in New York:  The Business Corporation Law).  To become an S Corp, the owner makes an election to be taxed in accordance with Subchapter S of the Internal Revenue Code.

2.  S Corps avoid Double Taxation:  A corporation is taxed at the corporate level/entity level on its profits and then shareholders are taxed on any distributions (dividends) received from the corporation -- resulting in double taxation.  An S Corp election means that there is no entity level/corporation tax, and instead shareholders are only taxed on the distributions thereby avoiding double taxation.

The ability to avoid double taxation is what makes the S Corp a popular choice for small businesses.

CONS:  

1.  Ownership restrictions:  Limited to 100 shareholders, all of whom must be individuals, and none of which can be foreigners (i.e., shareholders must be US citizens or residents).

2.  In contrast to the Limited Liability Company, there are more corporate formalities that must be observed (thereby increasing the cost of the maintenance as compared to an LLC).

3.  Can only have one class of stock:  so less flexible than a regular corporation ("C" Corp) or an LLC if want to vary the rights of shareholders; and

4.  Unlike a "C" Corp and an LLC, profits and losses must allocated to shareholders based on their share in the business.

IMPORTANT:  Like a "C" Corp, FICA is imposed only with respect to employee wages and not on distributions to shareholders. However, the IRS and state tax authorities see as a red flag an attempt to categorize wages as a distribution to shareholder where the shareholder-employees has not been deemed to have been reasonably compensated (paid wages) for the services performed withing the company.  Simply stated, a shareholder-employee cannot try to reduce FICA obligations by shifting what should be wages to a distribution on shares.     

The above does not constitute legal advice, and therefore if you are starting a business, make sure you discuss the proper structure with an attorney and an accountant.