S Corporations: Advantages and Disadvantages

An S Corporation is a corporation that elects to be a pass-through entity, meaning that the corporation does not get taxed at the corporate level, like a typical corporation, “C-Corp” does.  Rather an S-Corp, also known as a Subchapter S corporation, passes all income, losses, credit, and deductions to the shareholders so as to avoid double taxation.  The term double taxation refers to the fact that the corporation will be taxed initially at the corporate rate and then the shareholders will get taxed upon the income that they receive.  In an S-Corp the individual shareholder recognizes the gains and losses on their tax returns and is then taxed within their respective tax bracket.  Clearly, the biggest advantage an S-Corp has is that it avoids paying income tax as a corporation, consequently curtailing double taxation.  However, there are strict requirements in electing to be an S-Corp, so as with all important business decisions one must consider all of the various advantages and disadvantages.

The S-Corp was first introduced in 1958 upon the urging of President Dwight D. Eisenhower  in order to spur growth for small and family owned businesses that neither wanted to be a corporation nor be a partnership.  It was in this year that Congress created subchapter S of the tax code.  Nearly fifty years later, the S-Corp has evolved into the cornerstone of small business creation.  In 2007 the total amount of S-Corp’s in the U.S. topped 4.5 million; that’s double the amount of  C corporations in the U.S.  Clearly, businesses are interested in avoiding double taxation that comes along with being a C corporation, but also enjoy the notion of limited liability, which will be explored in more detail later.

While electing to form or convert into an S corporation is appealing to small businesses and large businesses alike, there must be certain statutory requirements that are met.  According to Internal Revenue Code (IRC §1361), these statutory requirements are:

• Cannot have more than 100 shareholders

• Cannot have a nonresident alien as a shareholder

• Cannot have more than one class of stock

• Only individuals, estates, certain trusts, and tax exempt organizations may be shareholders.  This ensures that the S corporation’s income is taxed at the individual rates, and

• The corporation must be formed within one of the fifty United States or the District of Columbia for federal tax purposes.

However there are no statutory limits for electing to form an S corporation due to invested capital, amount of sales revenue, or number of employees.  This last option makes any corporation, regardless of how large it may be eligible to form an S corporation.

According to IRC §1362, any business may elect to form an S corporation only by unanimous approval by the shareholders.  This election can occur at any time during the taxable year for the current taxable year or for the preceding taxable year.  Once the election is unanimously voted on, the S-Corp will be instituted as the permanent basis for its business, unless a majority of shareholders revoke such an election.  Upon reaching the agreement to be an S corporation, each shareholder must file IRS Form 2553 in order to be taxed as an S-Corp.  However, to ensure that an S-Corp keeps its tax status a shareholder cannot sell its stock to any type of partnership; in effect this would consequently negate the S-Corp’s pass-through status and thus it would be taxed as a regular corporation.  If this negating consequence arises to the dismay of the remaining shareholders, the IRS has placed IRC §1362(f) in effect whereas the S-Corp may repurchase the sold stock, reestablishing itself as an S-Corp for tax purposes.

Once a business decides to become an S corporation through unanimous election there are definitely some great advantages to being taxed federally as an S-Corp.  One of the biggest advantages is that the shareholders, whether one or one hundred, can enjoy limited liability.  A business that has limited liability ensures that the shareholders are not personally liable for any bad debts or legal action taken against the corporation.  Under the scope of limited liability only the S corporate assets are liable to creditors and/or other claimants.  There are two exceptions to the rule of limited liability.  One is when a shareholder personally guarantees the repayment of the debt.  If this were to occur, this shareholder would then be personally liable to ensure that the debt gets repaid.  The other exception is when the S corporation’s officers have conducted their business in a negligent fashion.  Therefore, creditors can issue law suits attacking S-Corps when a shareholder personally guarantees (signs) for loans and when officers conduct business in corrupt and negligent fashion.  Having stated the exceptions to the scope of limited liability, if the S-Corp conducts their business in an appropriate manner then that corporation will enjoy the protection of limited liability.

Another advantage of electing to be an S corporation is that it is fairly easy to raise capital due to the S-Corp’s ability to sell shares of stock to potential shareholders.  While the S-Corp is able to raise capital by selling stock, there a few stringent requirements detailed in IRC §1361.  There is only one type of stock; meaning there are not different classes of stock, such as preferred and common stock.  In addition, there can only be a total of one hundred shareholders and each shareholder must be a resident of the United States; this is done to ensure that the shareholder is capable of paying the federal taxes due.

The biggest advantage of electing to become an S corporation is the benefit of not paying double the amount of federal taxes.  A C-Corp will pay taxes on its ordinary income at the corporate level, which could be as high as 39%, and then the shareholders will pay taxes on the dividends they received.  However, due to an S corporation’s pass through status, an S corporation does not pay taxes on its ordinary income as it passes directly through the corporation to the shareholder.  Having said this, there is a major exception to this rule that should be noted.  If an S corporation has passive investment income (PII) greater than 25% their gross receipts for the year, the S-Corp is required to pay the maximum tax rate on that income at 35%.  If the S-Corp has their PII be 25% greater than their gross receipts income for three consecutive years, then the S corporation loses its S-Corp status and becomes a C-Corp. Regardless, in an S-Corp, the shareholders are then required to recognize the ordinary income on their individual tax return and pay their respective taxes on their income received from the S-Corp.  This manner of taxation is intended to promote small business growth by only recognizing the allocated ordinary income of the shareholders so as to allow small businesses to avoid paying taxes first at the corporate rates and then having each shareholder pay taxes again at the individual rates.

At the end of the year, an S corporation must report its ordinary income or loss on the 1120S (U.S. Income Tax Return for an S corporation).  On this return, the corporation recognizes how much money it has made or lost in the current taxable year.  Part of the 1120S requires that the S corporation to fill out the Schedule K and K1.  In Schedule K the S corporation recognizes deductions, capital investments, property distributions, as well as charitable contributions.  Although the S corporation is required by law to file a tax return, the 1120S with Schedule K attached, the S-Corp, itself, does not pay federal income tax.  Instead, upon completion of the tax return the S corporation is required to issue a Schedule K-1 to each of the shareholders.

The Schedule K-1 shows how much income each shareholder received based off of their percentage of shares held in the corporation, also known as an owner’s pro rata share of business income/loss.  For example, if Greg’s House, an S corporation, recognized an ordinary income of $500,000 in 2009 and had 4 shareholders, each holding 25% of the shares, then each shareholder would receive a Schedule K-1 whereas they recognized an ordinary income of $125,000.  The scenario could get a lot more complicated with more or less shareholders and varying percentages of shares held.  Use the same example above, however this time there are three shareholders.  One owns 75% of the shares, one holds 15% of the stock, and one holds 10% of the shares.  In this scenario owner 1 would receive a Schedule K-1 recognizing an ordinary income of $375,000.  Owner 2 would receive a Schedule K-1 recognizing an ordinary income in the amount of $75,000 and owner 3 would receive a Schedule K-1 for $50,000.  These amounts are then added to the individuals’ personal tax return, the 1040, where each owner pays taxes within their individual tax bracket.  Note: It’s important to understand that each jurisdiction and state has its own set of rules regarding the taxation of S corporations, however for the sake of simplicity this paper is only dealing with federal tax rules. Using the above example, if Greg’s House was a C-Corp, the $500,000 would first be taxed at 34% in 2009, meaning that the corporation would owe $170,000 to the IRS.  Then each shareholder would be taxed again on their individual return.  Hopefully, it is apparently clear that establishing a business as an S corporation leads to a great deal of tax savings for the business.

Like C corporations, S corporations have employees and officers that receive salary payments.  As with typical salary payments, both the employer and employee pay FICA and Medicare tax.  A benefit that an S corporation has over most other business entities is that it can avoid paying money in both FICA and medicare taxes.  This can be enacted by the officers taking a low salary in order to pay less tax on their wages and still receive significant income.  By taking a reasonable amount as salary for services provided, the shareholders and the business would pay significantly less in FICA and medicare taxes to the government than if all income was paid through wages.

While there are many advantages to setting up your business as a pass through entity such as an S corporation, there are also disadvantages.  An S corporation is costly to set up due the volatile nature of monitoring that it maintains its S-Corp eligibility.  Forming any business entity has initial costs in legal, accounting, and registration fees, however an S-Corp requires constant monitoring so as to avoid falling out of being recognized as a pass through entity instead of a taxable entity, such as a corporation.  Even though an S-Corp can sell stock, it can only sell one type of stock that is to remain common among all shareholders no matter what.  Moreover to only issuing one type of stock, another disadvantage that an S corporation has is that it can only have 100 shareholders, who are closely monitored by the IRS to ensure each shareholder meets the required criteria.  In addition to monitoring the eligibility requirements of each shareholder, the IRS is also scrutinizing whether or not “reasonable” wages were provided to the owners and officers of the S-Corp.  Clearly, the formation of an S corporation draws a lot of attention from the IRS, which is certainly the biggest disadvantage of establishing a business as such a corporate entity.

As stated above, one of the advantages of setting up a business as an S corporation lies in the fact that the corporation can raise capital by selling shares of stock to investors.  Although all stock must be exactly the same in terms of preference and character, an S-Corp can have up to 100 shareholders, each with varying degrees of percentage of shares held (pro rata share).  When an investor purchases S-Corp stock, that person becomes a shareholder in the S corporation and has an initial tax basis.  As per IRC section §351, the initial tax basis is equal to the cash invested plus the adjusted basis of any property transferred to the corporation in exchange for stock.  For example, assume that five individuals form an S corporation and each person contributed $20,000.  The tax basis for each shareholder is $20,000; regardless if the S-Corp took a loan of $200,000.  The reasoning behind this is that, due to an S-Corp having limited liability, the shareholders aren’t personally liable for any gains or losses incurred from the loan.  Having said this, there are ways in which the shareholders’ basis can be either negatively or positively adjusted.

IRC sections §1366 and §1367 provide a detailed explanation regarding how shareholders of S corporations can adjust their basis accordingly.  Shareholders are able to increase their basis in their stock by their share of the corporations’ income and gain for the year, while they are also able to decrease their basis if the S corporation incurred any losses.  Hypothetically, it would be beneficial for an individual to record losses because then they would get taxed at a lower rate due to having a smaller income.  However, there are limitations regarding how much a shareholder can deduct as a loss.  A shareholder cannot recognize a loss greater than their basis.  But the remainder of that loss can be carried forward to a more profitable year whereas the loss can fully be deducted without the basis becoming negative.  For example, go back to the previous example where each shareholder had a tax basis of $20,000.  Assume that in 2009, the S corporation had experienced a $35,000 operating loss.  When this occurred, each shareholder could only take a $20,000 loss bringing their basis to zero.  Due to the fact that the shareholder could only reduce their basis to zero for the current year, they would then carry-forward the remaining $15,000 loss to the next profitable year for the S corporation.

According to IRC section §1368, any property distributions, i.e. cash, given to a shareholder is a nontaxable return of investment that reduces that shareholders’ stock basis.  When property is distributed to a shareholder, it reduces the shareholders’ basis in the S-Corp by the amount of the property distribution; however the shareholder does not pay taxes on the property distribution when filing his individual tax return.  It should also be equally noted that a shareholder’s basis is increased or reduced when there is a loan or repayment of debt that the shareholder had loaned.

Conversely, a shareholder can increase his basis in an S corporation by loaning money to the S corporation or by simply buying more S corporation stock.  For example, a shareholder that has a $10,000 basis in the corporation would increase his basis in that corporation to $20,000 by either loaning or investing $10,000 more to the S-Corp. A shareholders basis in an S corporation is important when a shareholder is looking to sell or dispose of his shares and earlier mentioned it is important to determine if they can take losses on their personal returns.  Therefore, before the shareholder exits the S corporation, he should consult a tax professional to determine his basis in the company.

Like any business entity, an S corporation has its pros and its cons.  The greatest pro by far in forming an S corporation is avoiding paying double taxes, first at the corporate level and then at the individual level.  Avoiding paying the corporate tax, which is typically a high rate, is why an S corporation is an optimal business formation.  An S-Corp also allows the shareholders limited liability and therefore, not be personally responsible for any debt incurred.  All of S-Corps benefits are truly a result of this business formation being a pass through entity.  Although the pros of an S-Corp seem to outweigh the cons, it is important to realize that by forming an S-Corp, your business will be scrutinized by the government in such detail that it may be time consuming and costly to maintain eligibility requirements.  In addition to that disadvantage, other disadvantages are that the S-Corp can only have 100 shareholders and all the shares have to be in the same class, while a C-Corp can have an unlimited amount of shareholders and the stock can be in varying degrees of preferential treatment.  Prior to establishing a business an entrepreneur should look at all the pros and cons, including the tax implications in order to determine the best form of entity for that business.

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