S Corporation: A Definition

DISADVANTAGES

Paying Taxes on "Absent" Income

Most healthy corporations reinvest all or substantial portions of their profits into operations to fund growth. Dividends paid are therefore just a portion of all profits. In C corporations, stockholders only pay taxes on dividends, year to year, and are not liable for taxes on the total profit made. But when the S corporation retains its profits for growth, stockholders must pay taxes on that profit even though they do not get a check in the mail—and the higher the profits, the more rapid the growth, the higher the taxes. This structural arrangement can thus produce tensions between stockholder and the corporation—stockholders either required to keep "investing" in a going concern indirectly by paying its taxes or, conversely, pressuring the corporation to distribute more of its profits and thus potentially slowing the company's growth.

Taxed Fringe Benefits

Unlike C corporations—but like partnerships—S corporations may not deduct fringe benefits, given to shareholders who are also employees, as a business expense. As a result, shareholder-employees must pay taxes on those benefits. These rules apply to all shareholders who own more than two percent of the corporation's stock and are employees of the corporation. But all employees who are not stockholders may receive benefits without paying taxes.

Pay Vs. Profit Sharing

S corporations must be careful to pay stockholders who work for the corporation salaries "deemed reasonable" by industry standards. The temptation exists to pay stockholders low salaries and to compensate them, instead, from profits—thus avoiding payroll taxes. But if the stockholder-employee is not paid at a reasonable rate, the IRS may require the stockholder to pay payroll taxes on the totality of the income received from the S corporation—which may be substantial.

State and Local Taxes

S corporations are sanctioned under federal tax laws which may not be matched by local and state governments. Thus S corporations may still have to pay taxes as corporations to states and localities.

Record Keeping

S corporations must act like S corporations and maintain careful records. This is not, per se, a disadvantage of the form: after all, all businesses should keep good records. But some business owners see the S corporation as merely one way to escape liabilities by gaining the benefits of limited liability while continuing to operate as sole proprietorships. Under prevailing law, a corporation (S or C) must adhere to regular forms: it must separate personal from corporate accounts, hold regular directors' and shareholders' meetings, take minutes, and also use the appropriate corporate designation on its documents and stationary. Failing to adhere to these requirements, the S corporation may not prevail in court in the case of a liability action, with the result that the stockholders are severally and individually held to be liable.

TERMINATING S CORPORATION STATUS

An S corporation may voluntarily revoke its status if it finds that S status is no longer beneficial; it may also lose the status involuntarily. In the first case, a majority of the stockholders is required to make the decision, and a simple notice to the IRS is all that is required. In the second case, any act which disqualifies the corporation's eligibility for S status will result in the termination of that status effective on the date that the infraction occurs. An example of such a disqualification would be acquiring a single foreign stockholder living abroad. In either case, the corporation becomes a C corporation in the absence of S corporation status.

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