Limitations on S Corporations
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A corporations or an LLC can choose to be treated as an S corporation for Federal tax purposes. Electing to be treated as an S corporation allows income to flow through the corporation without being taxed until it is claimed as income by the shareholders. If you are considering whether to elect to be treated as an S corporation, there are certain IRS limitations that you should discuss with your accountant.
It may be a good decision for small business owners to choose to be treated as an S corporation for Federal tax purposes. This allows income to flow through the corporation without being taxed until it is claimed as income by the shareholders. This avoids double taxation of corporate income. This may be the right decision for your new company, but you should discuss this thoroughly with your accountant before you decide. The following are the limitations on S corporations that you should consider:
1. No more than 100 shareholders.
2. Only one class of stock.
3. Limits on deductibility of debt.
4. If S-Corp has a home office, the tax deduction is only a 2% miscellaneous itemized deduction on Schedule C, because it is treated for tax purposes as an employee business expense. In a partnership or LLC, a home office is a 100% deductible on Schedule E.
5. The S-Corp cannot reduce wages to avoid employment taxes, because it would directly conflict with its responsibility for its employee’s retirement benefits. Retirement plan contributions are based on a percentage of wages, not total S-Corp income.
6. All distributions by an S Corp must be made pro rata based upon stock ownership. An LLC can make disproportionate to members distributions as set forth in the operating agreement.
7. An S-Corp is required to file an extra tax return and more payroll forms, and this costs the company more money. Conversely, the LLC can file its deductions on the Schedule C and designate itself as a “disregarded entity.”(Note: a “disregarded entity” is an IRS term for a company that is not an S or a C corporation.
8. If an S-Corp has high value assets and it goes out of business, the S-Corp’s assets are sold at FMV to the shareholders, thereby causing shareholders to incur large capital gains. When an LLC closes, the assets are distributed to its members at basis, usually the cost of the assets.
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