The “S Corporation” has been popular with business owners since its inception back in 1958 to present day. Each year, there are over 4.5 million tax returns filed by S corporations, which is more than any other business entity. Why is the S corporation election so popular?
First, the S election provides an entity, whether a corporation or limited liability company, the opportunity to gain “flow through” treatment for income tax purposes. This means that instead of taxing income at the entity level, all income flows through to be taxed at the owner’s level.
Second, there are certain employment tax benefits for S corporation owners who take a reasonable salary from the business, that is subject to normal employment taxes, but then take additional profit distributions free of any employment or self-employment taxes.
Many business owners elect S status too quickly without considering other consequences of operating as an S corporation and without analyzing whether an S election is best for their particular business and circumstances. One consequence of electing S status is that there are restrictions on the ownership of the business – there can be no more than 100 shareholders, foreign ownership is prohibited, and another business entity cannot be an owner (subject to limited exceptions). These restrictions can hamper both foreign and domestic investment opportunities that arise as a business grows. In addition, an S corporation must treat its owners proportionately with regards to operating and liquidating distributions, which for economic purposes means that there is only one class of equity. The equity can be split into voting and nonvoting, but there is no opportunity to fashion any type of preferred equity.
In addition to the ownership restrictions, S corporation owners may also be restricted in the amount of losses from the business they can utilize, particularly with respect to depreciating financed equipment. In the startup phase, it may be crucial to understand how early losses will flow through the S corporation before making the election. It may also be difficult to extract appreciated assets out of the S corporation without triggering a taxable event for the owner.
While there are many advantages for business owners to elect S corporation status, there are also pitfalls to consider. One must weigh both in deciding when to make, or whether to make, the S election.