One of the most significant benefits of doing business as a solopreneur is that you get to decide what is best when it comes to all aspects of your company, including its tax structure. One choice that you will be faced with is whether to elect S corporation status for your business or organize it in some other way, such as an LLC. While you may be attracted to S corp status because of possible tax savings, you may want to consider the following disadvantages (and advantages) of S corporations and find out when it might be a good idea for you to consider going this route.
Understanding the challenges & disadvantages of S corporations
Many business advisors tout S corporations as an ideal solution for solo business owners. However, S corps doe have challenges/disadvantages that may make solopreneurs rethink the decision to structure their business-of-one in this way.
But fear not, lets get through the hard stuff, then we’ll tell you the potential upsides.
Some states/provinces don’t recognize it
If you’re electing S corp status for the tax advantages, you should be aware that you might not reap those benefits at the state level. The following jurisdictions don’t recognize S corp status:
- Tennessee
- New Hampshire
- Washington, D.C.
- New York City
In these places, your S corporation will be taxed just like a C corp without the pass-through taxation advantages. Although you will still enjoy the federal tax benefits, they won’t trickle down to the state level, which means you may not be saving as much money as you anticipated.
There’s lots of legwork involved
As a busy entrepreneur, you may want to keep things as streamlined as possible, including with your taxes. One of the biggest S corp disadvantages is that electing this status with the IRS will complicate your business operations and compliance.
For a sole proprietorship, registering your business often involves just a few forms, and in some states, you may not need to file paperwork at all from that point forward. If you wish to elect S corp status, you will have to:
- Submit articles of incorporation and bylaws
- Appoint a board of directors
- Keep and publish minutes for corporate meetings
- Announce and conduct shareholder meetings
Many of these items are far simpler with a S Corp of one, because you are the only member of the board, but it’s worth noting
It’s possible to lose your status
There are a few mistakes that can cause you to lose your S corp status with the IRS. Some of these include:
- Claiming disproportionate distributions among shareholders
- Reporting non-allowable or ineligible shareholders
- Not filing the required forms properly or on time
- Exceeding limits on retained earnings and passive income
If your S corp status is terminated for a rule violation, your business will default to taxation as a C corp, which can be costly if you aren’t prepared for this. Even if the mistake was inadvertent, it can be a long and complex process to restore S corp status.
Tax audits are much more likely
Because S corporations enjoy certain tax advantages, they are subject to greater scrutiny by the IRS. This is especially true when it comes to the way you characterize your payments to shareholder-employees as dividends or wages.
If the IRS must re-characterize your payments, you may lose deductions or become subject to employment tax liabilities. Once again, if this happens unexpectedly, it can cause significant issues for your business finances.
Using a system to keep clean S Corp books is critical to avoiding audits.
Stock and shareholder restrictions
There are significant S corporation disadvantages when it comes to your business investors. Electing S corporation status with the IRS means adhering to restrictions on the number and type of shareholders and stock your business can have and distribute. Currently, you can have only 100 shareholders.
All S corp shareholders must be U.S. citizens or permanent residents. If you try to add a shareholder who does not meet these requirements, you could lose your S corp status for this rule violation. Additionally, you can have only one class of stock.
How solopreneurs can overcome the downsides & disadvantage of S Corporations and benefit from this tax structure
Though S corporations require a lot of work and maintenance, there are many advantages to running one. Here are a few of the benefits you can reap when you file Form 2553 with the IRS.
Saving on taxes by taking a reasonable salary from the business
When you have an S corp, you can be an employee of your business instead of just the owner. You pay yourself a reasonable salary. Because you have income verification via payroll and you take a salary from the business, you can significantly reduce the amount of self-employment tax you pay. In turn, you get to keep more money in your personal pockets.
Claiming income and losses
The S corporation tax structure ensures that both the business income and losses are passed through to you. Because you’ll be able to claim those losses on your personal income taxes, you’ll likely enjoy a reduced personal tax liability, resulting in more savings.
Gaining a liability shield
Operating as an S corp shields you from liability if a customer or client decides to bring a lawsuit against you or a company comes to collect on a debt you owe. As an entrepreneur, you’ll be able to operate your business with peace of mind that your personal property and finances aren’t in danger because of your business activities.
When does it make sense for solopreneurs to elect S Corp status?
Solo entrepreneurs may have many different reasons for wanting to be taxed as an S corp. However, it’s a good idea to ensure that the benefits will outweigh the cost before you make the leap.
In many cases, this will start to happen when the business is generating $80,000 to $100,000 per year in gross revenue. This is the point at which the tax savings really start to kick in, allowing you to hold on to more of your money and experience the business growth you truly desire.
Making an informed decision about S Corporations
The biggest disadvantage of an S corp is how complex it can be to start and maintain. You’ll have a lot of upfront paperwork to file, and there are many different rules and parameters required to manage this type of entity.
Despite S corporation disadvantages, many solopreneurs just can’t resist the tax benefits. Others make the election because of the growth potential. Whatever your choice, make sure it’s an informed one.
Getting the right information and assistance ensures that you can reap the rewards of your tax status and avoid common pitfalls.