Just A Little About Business Entities:
A lot of the small business owners I’ve been meeting lately seem to already know the business entity they want for their existing or startup company (most want LLCs or S Corps). This knowledge may have been gained from the “grapevine” or through their own research. And by grapevine, I mean their friend/family who also has a business and/or starting a new business and somehow decided to choose either and LLC or an S Corp and have decided to spread the good news. Problem these news spreaders don't know enough about business entities to give their advice. It is important to choose the right entity from the get go and, therefore, very important to get the advice of a proper tax professional such as a CPA, Enrolled Agent, or tax/business attorney. The S Corporation is indeed an excellent business vehicle for small business owners, but it also has very stringent rules that must be followed and complex taxation rules. Let’s explore some of the disadvantages of S Corporations for small businesses since the ‘grapevine’ makes the Scorp seem like the perfect business vehicle.
1. Loss of lower tax bracket. 😖
C corporations are taxed at a lower tax bracket for the first 75K of income. This lower tax brackets is not available to S Corporations. This also doesn’t have that much effect on small business owners as most expect losses in their first few years, but for the tiny margin that will generate net income, this matters very much and can quickly create a downside to S Corporations.
2. Inadvertent Loss of S Corporation Status.
Once the S Corporation veil is lost, the company is just a regular C Corporation. The primary way to lose the S status is to no longer meet the requirements for the S status. For instance, one of the qualifying rules is that a non-resident alien can’t be a shareholder, therefore, having a non-resident alien as a shareholder, among other things, would cause the loss of the S Status. Now you might think “I don’t have to worry about that, I don’t have any non-resident alien shareholders”, but here’s the rub: if a shareholder-partner dies and transfers their interest to let’s say, a Canadian relative who qualifies as a non-resident alien, you will lose your S status, then you’ll just be a regular C Corporation, which can cause higher complexity and maybe result in higher taxes. You might be thinking it still doesn’t apply to you, but I want to emphasize that several other little things can trigger the loss of the S status due to the complexity of the rules surrounding the S Corp. The ‘little things that can trigger loss of S status” are beyond this scope of this particular blog, but will be discussed later.
3. Complex tax structures is another disadvantage.
Lastly, it definitely increases your cost of operations. If you are solo practitioner, you could file an LLC and be taxed as a Schedule C on your personal, which means your tax forms don’t change that much, but as an S Corporation, you’ll have to file a whole separate tax form (1120S) and file a Schedule E on your personal return. 4. Limits access to capital. For certain small businesses, those who are growing, the disadvantages of their S Corporations come from the limits on the number of shareholders and the single class of stock rule. These can severely limit your access to capital as they would not be able to issue their stocks at larger numbers.
The above disadvantages are by no means comprehensive, nor do they describe the complete picture for each company. Please reach out to us to get more clarity on your particular situation and about your business entity. Also be sure to be on the look out for more blogs and especially our next one… Little Things Than Can Trigger The Loss of Your S Corporation Status. Got questions about business? Comments? Contact us! We want to know your experiences with S Corporations, whether just starting out, just switching, been an S Corp all these years, or just researching...and the rainbows in between! Information contained in this article does not constitute a binding contract between the reader and the writer, nor does it constitute tax advice for the purposes of tax evasion. Again reach out to us about business entities particular to you to get the full picture.