Disadvantages of S Corporation
Although there are many advantages of an S corporation, it’s not always the best move for every business. Several important issues need to be considered:
- Fiscal Year: S corporations must report on a calendar-year basis unless they can justify another reporting period for business reasons. If they choose a different fiscal year, (which is still limited to September 30, October 31, or November 30), they must pay the IRS a deposit to cover the tax deferral provided by the fiscal year. In other words, the IRS requires the corporation to make a deposit that approximates the tax that would be due if the corporation were using a calendar year. This deposit acts as a prepayment, ensuring the IRS receives tax payments in a manner similar to calendar-year reporting.
- Accounting Methods: A C corporation that has become an S Corporation cannot change its accounting method from what it used as a C corporation without IRS approval.
- Cash Retention: Accumulating cash reserves can be challenging for an S corporation because shareholders need to get money out of the company to pay taxes on their pass-through income on their individual tax returns.
- Net Operating Loss Carryforwards: An S corporation cannot carry forward net operating losses from its time as a C corporation, which can be problematic if the losses are substantial. Sometimes it makes sense to stay as a C Corporation until these carry over losses are exhausted.
- Passive Investment Income: A C corporation converting to an S corporation may fail the conversion if the C Corp had more than 25% of its gross receipts from passive investment income over the past three years. This issue can be resolved by declaring a dividend before making the S corporation election. Dividends effectively reduce the amount of passive investment income on the corporation's books, helping it meet the requirement for conversion.
- Record Keeping: An S corporation must maintain records of its shareholders’ stock basis to determine the taxability of distributions and to manage the accumulated adjustments account. This is usually done by a tax accountant and this task adds costs to the tax preparation process.
- Taxable Built-In Gains: When a C corporation converts to an S corporation, it must pay taxes on any built-in gains from assets that appreciated in value before the conversion if these assets are sold or distributed within five years of the conversion date. This rule ensures that gains accrued under the C corporation structure are properly taxed, even after the conversion to an S corporation.
- Unplanned Termination: A shareholder transferring shares to an ineligible entity, such as a nonresident alien, can unintentionally terminate the corporation's S status.
- Double taxation on state level for some states: For example, California imposes a minimum franchise tax of $800 on S Corporations, regardless of income. This tax applies even if the corporation operates at a loss. If an S Corporation is profitable, it must pay 1.5% state income tax on its net income. This tax is on the corporation itself, not the shareholders. in their turn, shareholders of S Corporations must report their share of the corporation's income on their personal tax returns as well. They pay personal income on the same net income, which creates a second layer of taxation, albeit not on the same income directly taxed at the corporate level.
- SEP IRA Limitations: If you stay self-employed, your SEP IRA deduction is calculated based on your net income and is roughly 20% (a little bit less, but we won’t get into how to calculate it—that’s a different topic). However, with S Corps, SEP IRA deductions are a flat 25% of your W-2 wages, which S Corp owners want to keep low to avoid paying self-employment tax. This is where the solo 401(k) comes in, as it allows two-sided contributions: $22,500 (this number always increase from year to year) for the employee and 25% of the employee’s W-2 wages for the employer.
- Trapped Assets: Transferring assets from an S Corporation or converting them for personal use will trigger a taxable event, which can be significant. When assets are distributed to S Corp shareholders, they are valued at fair market value. Cash is straightforward, and vehicles generally aren’t a major issue, but real estate can be problematic. If the S Corp owner withdraws a building from the S Corp and the basis of the building is $400,000 while its fair market value (welcome to California) is $2,000,000, the owner will have to pay tax on a $1,600,000 gain. The worst part is that the owner may not have any cash on hand from the sale, as it is a phantom sale that never happened and cash never hit their bank account.
- Distribution of Profits: S-Corp shareholders receive their share of net ordinary business income (profits) based on their ownership percentage. In contrast, multi-member LLCs determine profit allocations through an Operating Agreement. Opting for S Corp status in some cases can lead to complications, particularly for silent partners, angel investors, or other unconventional ownership arrangements. We've talked about solution to this problem here.
- Other W-2 Income: If you have high W-2 income from your main job and want to set up an SCorp for your side earnings, an S Corp election can actually hurt you. This is because you’re already hitting the Social Security tax maximum on your W-2 wages, which has a limit on how much you can pay. If you start an S Corp for a side business, you would have to pay yourself a reasonable salary from the S Corp, and from that salary, you would need to pay self-employment taxes again: the employee portion (which you can recover when you file your personal tax return) and the employer portion (which is lost as it’s not refundable). To give you an idea, the lost employer portion of self-employment tax is 7.5% of wages. Despite this, an S Corp election can still be advantageous, especially if you benefit from PTET or the Qualified Business Income (QBI) deduction.