If you’re at a point of deciding what kind of business structure to form for your new enterprise, it’s important to know your options. LLCs and S corps have a lot in common, and also a lot of differences. The tax differences between these two are especially important to understand.
Any entrepreneur can appreciate the benefits of an S corporation – the protective separation, the pass through taxes, etc. But many entrepreneurs would be wise to steer clear of this business structure due to the disadvantages of an s corporation.
If you're not aware of the disadvantages of an S corporation, they can have disastrous effects on your long term goals and overall vision. Business owners who create S corps and later express regret cite many common disadvantages to the structure. Continue reading for five disadvantages of an S corporation you should know before you choosing this filing status.
Limited Ownership to 100 Shareholders
One of the biggest disadvantages of an S corporation is particularly tricky because it’s hard to see as a disadvantage at first. By law, S corps may not have more than 100 owners. While this may be okay in the beginning, what happens when your business grows, expands, and makes strides throughout our economy.
Business owners often use shares as incentive for hiring; and if your business needs more than 100 people to operate, this is not an option. Even though you may not have 100 shareholders at the moment, consider your overall vision. How long before your business gets big enough to where this becomes a hindrance?
No Non-US Citizen/Permanent Resident Shareholders
To put it bluntly, US law does not permit non-citizens or non-permanent residents to be owners of S corporations. Every entrepreneur needs to consider the near future, long term future, and medium term future of the business vision.
Regardless of anyone’s opinion on the bureaucracy of the immigration system, it’s an undeniable fact: the United States is a country of immigrants. Half of our Fortune 500 companies were started or co-founded by foreign born entrepreneurs. Nearly three quarters of all the tech talent in Silicon Valley is foreign born workers.
Even if you currently don’t have any non-citizen or non-permanent resident partners or employees, you may in the future. It’s a very real possibility for nearly every single entrepreneur. And if you want to offer shares to attract them, you’re going to run into problems with an S corporation.
You may otherwise need to rely on the base salary as your only measuring stick for top talent. (This can be written off on taxes, but may not be worth it – again, you’ll need to plan smartly and consider this before incorporating as an S corp.)
Cannot Be Owned by Other Corporations
Did you know your S corporation cannot be owned by other S corps, C corps or LLCs? Was operating as a subsidiary part of your plan? If so, an S corp may be the wrong type of business entity.
Also – while it’s not the first thing entrepreneurs typically think of when forming a new company, it’s important to ask yourself: are you planning to eventually sell this company? Will this be an option in the future?
Selling a successful company can be a very, very profitable move – unless tax and business laws prevent the sale. The structure may bring success in the short term, but you need to always remember to consider the long term with your business plans.
Limited Control Subject to a Board of Directors
Depending on your vision and your leadership style, you may find a lack of freedom, speed, and compliance to be a headache. With an S corp, you have a board of directors that controls high level business decisions.
Your day-to-day operations may be under your control without tight scrutiny, and you can nominate whomever you like to run things; but big decisions that affect the direction of the company are always put to a vote by the board. If this is not your style, an S corp may not be right for your.
A Closer Eye on Your Taxes by the IRS
Because your company’s payments to its shareholders and employees can come in the form of either dividends or salaries, there are differences in how it's taxed. And because of these differences, your business will naturally be subject to a more watchful eye and stricter scrutiny from the Internal Revenue Service.
If you believe your taxes are legitimate, uncomplicated and lawful, then there shouldn’t be any problems, per se, but being audited is always time consuming and annoying. And if your taxes are unlawful, your likelihood of going to prison is much higher. So, again, be honest with yourself and acknowledge your behavior before forming an S corp!
Contact John F. Dennehy CPA
Choosing the best business entity is a big deal. It can impact your business today and for several years to come. Fortunately, you don't have to do it alone. The experts at John F. Dennehy CPA offer decades of experience helping business owners choose the best type of business.
Contact John F. Dennehy Jr. CPA , PC today to learn more about the benefits and disadvantages of an S corporation.