Benefits & Drawbacks to an S-Corporation for Small Businesses

Starting a small business is an exhausting exercise in patience, business savvy and tolerance. There are hundreds of decisions to make, and if you don't have the answers right away, the research could drive anyone to the brink of insanity. But if you start with some of the larger questions - such as rather to incorporate - you will be better prepared to tackle the smaller problems later.

An S-Corporation is one of the most popular ways that small businesses are begun with respect to benefits and drawbacks. It is nearly impossible to find the perfect combination, but if you study each type of business, you can weigh the pros and cons.

An S-Corporation is the leading choice for small businesses largely because of what the name means - a Small Business Corporation. The S-Corporation status pertains mainly to its classification with the IRS. Rather than paying taxes on a corporate tax structure - which may not be feasible for a start-up small business - it allows a corporation to operate within a partnership tax structure.

S-Corporation Benefits

First of all, the tax system for an S-Corporation allows small businesses to operate based on a "pass-through" tax system similar to that of a Limited Liability Corporation (LLC). In a C-corporation, the company itself pays income tax on its profits and, should those profits be distributed to shareholders, the shareholders must also pay distribution taxes.

When choosing S-Corporation status, the owners pass the profits or losses of the company to the shareholders, who in turn allocate those figures on their personal income tax returns. This method has obvious benefits to a corporation if the owners expect to experience an initial loss in the beginning months of their business.

S-Corporation Drawbacks

Passing income through to shareholders will sometimes prove to be a disadvantage. If the business is profitable from the very beginning, the shareholders then have to pay income tax on their share of that income, even when those profits are not distributed to them.

This is where a C-Corporation is advantageous because profits can be used to expand and improve the business without forcing the shareholders to pay taxes on the net profits

Reasonable salaries paid to employees are tax deductible for both S-Corporations and C-corporations. However, with an S-Corporation, fringe benefits may not be deductible, while they will be in a C-Corporation.

And although losses are "passed through" to shareholders in an S-Corporation, these losses are not tax deductible for shareholders who have no direct participation in the company. This, in turn, can result in higher taxes overall.

S-Corporation Requirements

Some businesses qualify for S-Corporation status, while others do not.

In order to elect S-Corporation status, the company may have only one class of stock. The business can have no more than 35 shareholders, although couples count as only one shareholder, even though they might own individual shares.

All shareholders must be residents and individual entities, versus another corporation holding stock. All of the shareholders must agree to the S-Corporation status, and there is a limit to how much money the company can earn from investments.