S Corporation Advantages & Disadvantages

An S Corporation is one of several optimal structures for a small business. It blends some of the benefits of a sole proprietorship with those of a C Corporation. An S Corporation is often considered alongside a limited liability company when someone is looking for something more formal than a sole proprietorship.

Like an LLC, an S Corporation has pass-through taxation, which means you only pay taxes once. The profits of the business are distributed to owners, who then pay taxes on their share of the earnings. In contrast, a C Corporation experiences double-taxation. The business pays taxes on corporate earnings and each shareholder pays taxes on his share of the distributed earnings. By working for the business and receiving a salary, an S Corporation owner also may avoid hefty self-employment penalties common with a sole proprietorship.

An S Corporation is easy to set up relative to other formal business structures. Some people operate as sole proprietors just to avoid formalizing their operation. However, an S Corporation allows for greater credibility with customers, partners and suppliers. Similar to a C Corporation or LLC, an S Corporation also insulates the personal assets of owners, because the business is treated as a separate legal entity from its owners. If the company is sued, for instance, the business assets are at risk, but not the financial assets of owners.

An S Corporation does have a few more setup and ownership restrictions than an LLC. First, you must be a U.S. citizen or legal resident to form an S Corporation. Also, whereas C Corporations and LLC allow unlimited ownership, an S Corporation is limited to 100 shareholders. Profit distribution or dividends must align with a shareholder's level of ownership. If someone owns 5 percent of the business, he must receive 5 percent of income distributions. LLCs have more distribution flexibility.

There are more costs to setting up an S Corporation than there are with an LLC. As with C Corporations, you file formal legal documents and pay related fees to set up an S Corporation. Annual report filing fees and franchise fees are additional costs that you may pay with an S Corporation that you don't incur with a partnership or sole proprietorship.