Part 3 – Disadvantages of an S Corp
Entrepreneurs face several choices when structuring their business. This series of posts is intended to help them evaluate whether or not they should utilize S Corp status. The first post covered what an S Corp actually is (a tax status, not a business entity) and reviewed the benefits of an S Corp over a C Corp (pass-through taxation and the QBI deduction). The second post compared the benefits of an S Corp over an LLC (self-employment-tax savings). In this final post, I’ll discuss some of the reasons you may not want to elect S Corp status for your business.
A quick caveat: As explained in the first post, because an S Corp isn’t itself an entity, the company must first be formed as a C Corp or an LLC. Due to this, a company will face certain advantages and disadvantages in the underlying entity form. For example, although an LLC and a C Corp that elects S Corp status will be similar in that they have pass-through taxation, the corporate entity will face much more rigid formalities because the underlying entity is a corporation. This post will not focus on these entity-specific disadvantages, but instead on some universal disadvantages of electing S Corp status.
Disadvantages of S Corp Status
1) Restrictions on Shareholders
The IRS imposes multiple restrictions relating to an S Corp’s shareholders. It limits the number of shareholders of an S Corp to a maximum of 100. The IRS also restricts who these shareholders can be: Only natural persons and certain trusts, estates, and non-profits. Further, the natural persons must either be a U.S. citizen or resident. This means that an S Corp cannot be owned by an LLC, a corporation, a partnership, or a non-resident alien. Failing to adhere to these restrictions will jeopardize a company’s S Corp status.
2) Restrictions on Stock and Allocations
An S Corp can only have one class of stock. This limitation has multiple implications. Most obviously, it precludes the ability to issue preferred stock, or profits interests. This also means that the S Corp cannot change its profit-sharing ratios. In an LLC, for example, the membership interest in the company does not have to match the allocation percentage of profits and losses – a member could have 60% of the voting rights but be entitled to only 40% of the profits/losses of the company. An S corporation, on the other hand, must allocate profits and losses among the owners based strictly on the percentage of ownership or number of shares held.
3) Increased Scrutiny from IRS
As discussed in the last post, owners of an S Corp split income into two parts: salaries and dividends, with salaries taxed at a higher rate. Because of the potential for fraud in making these apportionments, the IRS will keep a close watch as to how S Corp owners divide the income and will take notice of lopsided divisions. If the IRS determines the salary is unreasonable, then it can step in to change the proportions, leading to unexpectedly higher taxes.
4) Investor Preference
In the eyes of investors, the S Corp status tends to make a corporation less appealing and fails to transform an LLC into a more appealing entity. Investors tend to view S Corps unfavorably for a few different reasons. First, certain investors simply may not be able to invest in an S Corp. Many venture capitalists invest through limited liability companies, partnerships, or some combination of multiple entities. Due to the requirement that owners must be natural persons, such structures would preclude their investment.
Further, for the investors who are able to invest, the company is only able to offer one class of stock. Although the stock can have voting and non-voting shares, the economic terms must remain the same. As a result, the company would be unable to offer convertible preferred stock, as is common in early-stage investing.
Moreover, investors tend to dislike the pass-through taxation associated with S Corps. Most venture capitalists invest for long-term gains, not immediate profits. As such, the companies they target are not expected to turn a profit for many years, making the benefit of pass-through taxation largely irrelevant. Meanwhile, the pass-through taxation complicates investors’ tax returns and saddles them with additional accounting expenses as they process Form K-1s and incorporate the S Corp’s profits or losses into their tax filings.
The S Corp was created in 1958 to encourage small and family-owned business to open and operate in America. Many of the restrictions placed on S Corps are to ensure that these businesses are the ones able to take advantage of the tax status. If these restrictions dissuade you from electing S Corp status, then it’s likely that Congress didn’t have your business in mind when they created Subchapter S of the Tax code.
That said, many business do fit the mold for S Corp status, and it’s becoming increasingly popular. Indeed, the IRS estimates that there are over 5 million S Corps operating in the United States today.
What this means for any individual business, is that its owners should think about its growth goals and its future before making a decision as to S Corp status. If it is a growth-oriented startup looking to raise capital from outside investors, then an S Corp may not be optimal. But if it is a local, family-owned small-business, then an S Corp may be worth considering.
If you are trying to decide between various business forms, want to form an S Corp, or have any questions about business entities, don’t hesitate give us a call, or reach out to email@example.com.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.