A Drawback of the S Corporation

by Dan Ketchum

The S corporation business structure serves as a sort of middle ground between a C -- or regular -- corporation and a limited liability company (LLC). S corporations operate in much the same fashion as C corporations, but have a limited liability tax structure, allowing business profits to pass through to the owners rather than the corporation. Though this may sound like a good deal, S corporations come with a fair share of drawbacks, mostly related to taxation and rigid structure.


S corporation shareholders and owners face numerous taxation restrictions. These shareholders cannot deduct corporate tax losses if said losses amount to more than their total investment -- or “basis” -- in the company. Likewise, S corporations may not deduct fringe benefits given to employee-shareholders if said employee-shareholder owns more than 2 percent of the business. These businesses must submit detailed balance sheets for each tax return, which is often a costly accounting procedure.


S corporations have something of an inflexible nature. From the get go, this business structure imposes numerous non-negotiable requirements. For instance, these corporations cannot have more than 100 shareholders -- or less in some states -- and each shareholder must be a United States citizen. S corporations require the election of a board of directors, which must conduct annual meetings and filing reports. Each shareholder can only profit in proportion to her interest in the business, with no exceptions. The perpetual structure of S corporations can last even beyond the death or withdrawal of its shareholders.


Unlike sole proprietorships, S corporations require state-specific filing fees. Neither sole proprietorships nor LLCs require the formation of a board of directors. LLCs and sole proprietorships also allow business owners and members to create management structure, while S corporations do not. In general, LLCs allow for a more flexible allocation of profits and losses and don't exert as many restrictions on shareholders.


Typically, S corporations let business owners pass business losses onto their personal income taxes, which helps business owners offset income from other sources. The IRS does not require S corporation shareholders to pay self-employment taxes, which can add up to 15 percent of total personal income. S corporations also avoid the double taxation imposed on C corporations, which must pay taxes at the corporate and shareholder level. As long as S corporation shareholders observe IRS regulations, they have the right to sell ownership interest.

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