Electing as an S Corporation: Benefits, Drawbacks, and When to Make the Choice

For business owners, choosing the right business structure can have significant tax implications and affect how profits are distributed, how taxes are filed, and even what deductions are available. One option that might be appealing to many small businesses is to elect S Corporation (S-Corp) status. But is it the right choice for your business? Let’s break down the pros and cons and consider when it might be the right time to make this election.

What is an S Corporation?

An S Corporation, often called an “S-Corp,” is not a type of business entity like an LLC or corporation, but rather a tax classification that businesses can choose. When a business elects S-Corp status, it agrees to special tax treatment under Subchapter S of the Internal Revenue Code, which can help owners avoid double taxation by allowing profits and losses to pass directly to shareholders.

To elect S-Corp status, a business must:

1. Be a domestic corporation.

2. Have only allowable shareholders, which include individuals, certain trusts, and estates.

3. Not have more than 100 shareholders.

4. Have only one class of stock.

If your business meets these requirements, filing IRS Form 2553 can initiate S-Corp status.

Benefits of Electing S-Corp Status

1. Tax Savings Through Pass-Through Taxation
   The main advantage of S-Corp status is the ability to avoid double taxation. Unlike a traditional corporation (C-Corp), which pays corporate income tax and then taxes shareholders on any dividends, an S-Corp “passes through” income to shareholders. This means profits (or losses) appear on each shareholder’s individual tax return, avoiding federal corporate tax.

2. Reduced Self-Employment Taxes
   If you are a sole proprietor or an LLC, you’ll typically pay self-employment tax on your business income, which includes Social Security and Medicare. With an S-Corp, however, you can pay yourself a "reasonable salary" as an employee. Only your salary is subject to payroll taxes, while the remaining profit distribution is not. This can reduce your total tax liability, especially as the business grows and becomes more profitable.

3. Simplified Income Distribution
   S-Corp status allows business owners to take distributions (often referred to as “dividends”) from their business income. These distributions are not subject to employment taxes, which can offer considerable savings. However, this benefit only applies if the IRS deems the owner’s salary “reasonable.” If the IRS suspects the salary is artificially low, they may reclassify the income and apply back taxes and penalties.

4. Business Deduction Options
   S-Corps can also deduct business expenses, including health insurance and retirement plans for employees, which can lower overall taxable income.

Drawbacks of Electing S-Corp Status

1. Administrative Costs and Complexity
   Maintaining S-Corp status requires additional administrative tasks, such as payroll and recordkeeping, compared to sole proprietorships or LLCs. For small businesses with limited resources, this can feel burdensome. Additionally, S-Corps must follow formalities like issuing stock and holding annual shareholder meetings.

2. Reasonable Compensation Requirement
   As mentioned, the IRS requires S-Corp owners to take a reasonable salary. If the IRS finds that an owner is using an S-Corp to avoid self-employment taxes (by not taking a reasonable salary and only taking distributions), they may impose penalties.

3. Limitations on Types of Shareholders and Stock
   S-Corps cannot have more than 100 shareholders and can only have one class of stock. This structure can limit growth potential if the business hopes to bring in new investors or shareholders in the future. Additionally, shareholders must generally be U.S. citizens or residents, which could be restrictive for some businesses.

4. State Taxes May Apply Differently
   While S-Corp status provides federal tax benefits, some states may impose their own corporate income tax on S-Corps or require additional fees. It’s essential to check state-specific requirements before making the election.

When Should You Consider Electing S-Corp Status?

1. When Your Business is Profitable and Growing
   If your business is generating substantial profits beyond what you need as personal income, S-Corp status can be a valuable tax-saving strategy. The higher the income, the more beneficial it may be to take advantage of the self-employment tax savings on distributions.

2. When You Want to Save on Self-Employment Taxes
   For LLC owners or sole proprietors paying high self-employment taxes, the opportunity to pay yourself a reasonable salary and take the rest as distributions can offer significant savings.

3. If You’re Seeking Simplicity and Flexibility Compared to a C Corporation
   If you’re interested in growing your business but want to avoid the double taxation of a C-Corp, S-Corp status offers a beneficial middle ground. It allows you to scale without immediately taking on the complexities of a C-Corp.

4. When You’re Prepared for Increased Recordkeeping and Compliance
   Businesses that are already equipped with solid bookkeeping practices may find S-Corp status manageable, especially if they’re able to hire an accountant. If you’re prepared to maintain payroll and issue regular distributions, S-Corp status might be a great fit.

Final Thoughts: Is S-Corp Right for You?

Electing S-Corp status can be advantageous, particularly for growing businesses with steady profits. However, this decision isn’t one-size-fits-all. Before choosing S-Corp status, consult a tax advisor or accountant to assess your business’s specific needs and long-term goals. Tax savings are compelling, but only if the administrative requirements and limitations align with your business structure and ambitions.

An S-Corp election can be powerful when used thoughtfully, and with the right guidance, it may open doors to tax efficiency and growth.