S-corp is NOT Always the Answer

This post dives into a topic that is often overlooked amidst the flood of advice on why you should form an S-corporation (S-Corp). While S-Corps have undeniable benefits, it’s essential to also understand their limitations and potential drawbacks.

Use this blog to balance the conversation with key reasons why an S-Corp might not be the best choice for your business.

1. Cost of Additional Tax Returns

One of the first and most common downsides to forming an S-Corp is the additional tax return requirements. Unlike a sole proprietorship or a simple LLC, which may only require a single tax return, an S-Corp requires a separate corporate tax return (Form 1120-S).

This isn’t just a minor inconvenience—it’s an additional cost. The average price for preparing an S-Corp return ranges from $1,500 to $5,000, depending on the complexity of your business and your accountant's fees.

2. Loss Years with Wages

If your business experiences a loss in any given year, but you’re still paying yourself a salary as an owner, you’ll pay more taxes than an LLC taxed as a partnership. We normally see this when an owner isn’t aware they are having a loss year until they are more than halfway through the year and have been paying themselves a salary up to that point.

If your business swings from profitable to unprofitable based on the year, then an S-Corp may not be for you.

3. Basis Limitations, Especially in Real Estate

Basis limitations in an S-Corp can be particularly problematic for real estate investors. Shareholders of S-Corps can only deduct losses up to their basis in the corporation, which includes money you’ve invested directly or loaned to the company.  It does not include money the company borrows.  LLCs taxed as partnerships can, in certain circumstances, get basis for company-borrowed capital.

This limitation can become a significant hurdle, especially in the real estate world where depreciation often creates significant paper losses. If you don’t have enough basis, you won’t be able to deduct these losses on your personal tax return, making the S-Corp structure a big no-no for real estate ventures.

4. Employing Your Kids

If you’re thinking about employing your children as part of a family business, an S-Corp will negate some of the tax benefits. In sole proprietorships or partnerships, employing your kids under 18 can be an attractive tax strategy because wages paid to them are not subject to Social Security or Medicare taxes.

However, with an S-Corp, those wages are subject to payroll taxes, eliminating one of the key benefits of family employment strategies.

5. You Can’t Have an LLC as an Owner

One of the restrictions of S-Corps is that you cannot have another LLC as an owner. Ownership is limited to individuals, certain trusts, and estates. This limitation might not seem significant at first, but if you are looking to create a more complex business structure that involves multiple entities, this rule can create barriers to achieving the desired legal and tax arrangements.

6. Equal Distributions Only

An S-Corp is required to distribute income to shareholders based on ownership percentages. This means that if you own 50% of the company, you’ll receive 50% of the distributions, regardless of how much effort or capital you have contributed compared to other shareholders.

This inflexibility can be problematic if one shareholder is doing more work than another, or if there’s a need for differentiated payouts based on performance or capital contributions.

7. 2% Shareholder Limitation on Fringe Benefits

Fringe benefits are a popular perk for many small business owners, but if you own 2% or more of an S-Corp, you may find your options limited. Health insurance, certain retirement plan contributions, and other benefits provided to employees are typically tax-deductible by the business.

However, in an S-Corp, shareholders owning 2% or more of the company cannot receive these benefits tax-free, and must include the value of the benefits as part of their income, negating some of the tax savings.  If allowed, the 2% shareholder can deduct on their personal return, but some fringe benefits may not get the deduction.

8. Distributions of Property

An S-Corp can make it more challenging to distribute property to its shareholders. Unlike a partnership or LLC taxed as a partnership, which allows more flexibility when transferring appreciated property, an S-Corp treats these distributions as taxable events.

This can result in unexpected tax bills for shareholders, especially if the property being distributed has appreciated significantly in value.

9. Inside and Outside Basis Issues for Inheritance

When it comes to passing on your business through inheritance, basis issues can be more complicated in an S-Corp than in other structures like an LLC. The "inside basis" (the value of the assets within the company) and the "outside basis" (the value of your shares) are not always aligned in an S-Corp.

This can create complications when it comes to estate planning, and heirs may face a larger tax bill than they would with a more flexible structure like an LLC.

10. No second class of stock

If you’re thinking of offering a second class of stock as part of your employee compensation package, S-Corps are not a good choice. S-Corps can only issue one class of stock.  So, if you intend to have preferred shares, no non-voting shares, etc.  All stock must have the same class and same rights.

11. Shareholder Loan Reporting

Loans between shareholders and the S-Corp must be carefully documented and reported on your tax return to avoid reclassification by the IRS as disguised distributions. If the loans aren’t properly structured and documented, they can create tax problems for both the company and the shareholders.

While S-Corps can offer valuable benefits (mostly self-employment tax savings) they come with several limitations and potential pitfalls. Before jumping on the S-Corp bandwagon, it's crucial to evaluate whether these downsides might outweigh the benefits for your particular business situation.