What are the advantages and disadvantages of switching from a C corporation to a S corporation?

Question

I realize the income flows through to the shareholders but what are the other issues?

Answer 1

This is an unbelievably involved question. For ease of answering, I'll assume that you're not a personal service corporation. The "S" has the advantage of pass through income/loss, which might be a good thing. Also, there's a certain level of savings with employment taxes. As long as you take out a "reasonable salary" (that's a big decision right there), the rest of your income will pass through to your individual tax return and be taxed at your individual income tax rate. Another thing that's kind of nice with the S is that it gives you some flexibility on cash flow. Say for instance with a C Corp, you want to reduce your year end liability so you take out a bonus from the corporation. If you're short on cash, you'll have to loan it right back to the corporation to make sure your cash flow doesn't go south. With an S Corp, you've paid taxes on the pass through income, so you can take out the cash from the corporation when it becomes available. For example, let's say you had $30,000 of pass through income reported on your 2006 tax return. You can't afford to make a withdrawal because you have too much money tied up in receivables, but you expect to get paid in June 2007. You pay the tax on your 1040, but you don't make the withdrawal until 2007. That way, you've kept your cash available without having to loan money back to the corporation (also without the expense of paying your employment taxes on a bonus and also paying yourself interest from the C Corp on the officer loan).

There are some downsides to the S corporation, though. The biggest issue as far as I'm concerned is what is referred to as "shareholder basis". This is a complicated issue that is best discussed one on one with your accountant, but I'll try to explain it as succintly as possible. If you start generating losses within the S corp, there may come a point where your losses exceed your personal stake in the corporation. A C corp has a "retained earnings account": an S has "accumulated adjustments account (AAA)", If the AAA isn't a greater value than the loss, you can't deduct the loss.

Another downside of the S is that the IRS has recently starting gunning for them. Years ago, I never saw a small business with an S get audited. Now, the IRS sees the potential for employment tax evasion, amongst other things, so they've picked a new target.

Again, there are so many issues on this that are too complicated to explain here. If you have appreciated assets, the transfer to the S could create some tax liability, along with some other issues regarding the transfer of C stock as opposed to S stock.

Hope that helped and didn't confuse you more!

Answer 2

It sounds like you already know of the primary tax and income benefit, the avoidance of double-taxation (at both the corporate and the personal levels). That is really the quintessential benefit of the "s" corp, which gets its name from the sub-section of the tax code that permits the income flow-through, single taxation that make the form so popular among small business owners.

As for disadvantages, the category certainly has some restrictions. These are largely designed, however, to target the tax break to small business owners, so they rarely pose significant problems for most businesses. They include things like limitations on shareholders (e.g., must be natural persons instead of corporations, must be U.S. citizens or legal residents, can not exceed a maximum number set by law) that overall tend to make the S-corp election incompatible with being a publicly-traded company or part of a larger business organization. That can limit the capitalization of the corporation, but any company that is getting that big is probably outgrowing the S-corp form anyway.

I hope that helps out. You might also look at the resources on findlaw.com, which I have often recommended to clients, friends, and family.

Answer 3

i think the major advantage is that under an S Corp you can show losses (when filing the 1120S)

Answer 4

the S has tax benefits. You should be asking your accountant this question.