7 Reasons to Avoid an S-Corporation (S-Corp)

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Why You Should Avoid an S-Corp

These days, it seems impossible to open TikTok (or any other social media platform) without seeing an attention-grabbing video about how you’re donating tons of tax dollars to the IRS by not using an S-Corporation (eye roll).

The shoot-from-the-hip suggestion of setting up an S-Corporation for your small business has been beaten to death by accountants and other laypeople who know just enough to be dangerous (like your cousin’s friend’s sister’s boyfriend who owns 3 laundromats and drives a Lamborghini).

It’s true—utilizing an S-Corporation can be a great way to save some money on self-employment tax. But, S-Corp status is not the “end-all-be-all” that it’s often made out to be. In this blog post, we will consider 7 reasons why you might want to avoid S-Corp status.

1. You’re Just Getting Started

Maybe you’re still working a 9-to-5 and you’re starting to build your side hustle. Or, maybe your business is already up and running and you’re making some decent money. Please—I beg you—don’t go out and pay an online legal service to help you set up an S-Corporation.

At my firm, we don’t recommend even considering S-Corp status until your business is profiting (after expenses) at least $80,000 per year and you have confidence that your business has “staying power.” If you’ve reached this point in your business, see #7 below.

2. You Would Consider Taking on Investors

S-Corporations have strict rules about who can be shareholders. To be specific, those shareholder requirements are:

• • Shareholders must be a natural person (no corporations or partnerships as shareholders)

• • Shareholders must be U.S. citizens or legal residents (green card holders)

• • There can be no more than 100 total shareholders

If you can envision a scenario in which you may take on a business partner or an investor, you should avoid making an S-Corp election so that you can keep your options open. In my cases, potential investors will want to invest through a family trust or LLC, which is prohibited if the business is taxed as an S-Corp.

Additionally, S-Corps are limited to one class of stock and, thus, require “pro rata” distributions of profits. What does this mean for you? All shares of S-Corporation stock are considered “common stock”. This means that all shareholders are entitled to a pro rata (equal according to ownership percentage) distribution of profit.

So, if you take on a 50% shareholder, you can’t take profit out of your S-Corp without giving your investor the exact same amount.

3. Compliance is More Costly & Time Consuming

Put plainly, S-Corps take more time and money to operate. For starters, the IRS requires that shareholders pay themselves a “reasonable salary”. You can read about what that means here.

Paying yourself a reasonable salary will require setting up and paying for a payroll service (like Gusto). You’ll also need to make sure that your salary is “reasonable” in the eyes of the IRS. Hint: it’s not a cut-and-dry number or percentage.

In order to make informed decisions about the reasonableness of your salary, you’ll need to keep up-to-date bookkeeping records. This will cost you time or money depending on if you DIY it or hire an accountant to help you. And, since we’re talking about hiring an accountant, you’ll probably need to do that to prepare your S-Corporation tax return.

S-Corp returns are completely separate from your personal tax return and they require technical accounting knowledge to prepare. Accountants typically charge twice as much to prepare an S-Corp return as they do a personal return!

4. Smaller 20% Qualified Business Income (QBI) Deduction

The IRS offers a free, 20% deduction on your net income from pass-through businesses. This includes sole proprietorships, S-Corporations, and partnerships.

Effectively, the IRS simply slashes 20% of your net business income off of your taxable income. QBI, along with the standard deduction, are the only deductions that don’t actually require you to spend money.

For those under the QBI threshold, businesses taxed as a sole proprietorship will enjoy a higher QBI deduction due to the reasonable salary requirement that S-Corps face. For instance, a sole proprietorship business making $100k per year will receive a $20k QBI deduction.

Whereas, if the business is taxed as an S-Corp, the business will deduct the shareholder’s salary before calculating QBI. In this example, if the S-Corp paid the shareholder a salary of $40k, the QBI deduction on the remaining $60k of profit would be $12k.

5. Your State is not S-Corp Friendly

In my experience, this is—by far—the most overlooked factor when deciding if an S-Corporation is right for your small business. Most people only consider the federal self-employment tax savings and forget to consider state franchise taxes.

For instance, in Tennessee, S-Corporations are subject to a 6.5% excise tax on their net income. While the 6.5% excise tax is less than the self-employment tax rate of 15.3%, the math changes once social security maxes out at $160,200 (2023) and only medicare tax remains (at a max rate of 3.8%). I’ll take 3.8% over 6.5% any day. In other states (like California), S-Corporations are more of a “slam dunk”.

6. You Plan to Hold Real Estate

S-Corps and investment real estate mix like oil and water. The benefit of an S-Corporation is avoiding self-employment tax on non-passive business income.

Normally, real estate held for investment is considered a passive activity, which means it’s already not subject to self-employment tax. So, holding real estate in an S-Corp provides absolutely zero tax benefit whatsoever.

The other problem with holding real estate in an S-Corp is that removing assets from an S-Corporation results in a taxable event.

If you ever decided you wanted to move into one of your investment properties, or if you just decided you didn’t want to keep up with the S-Corp, transferring the title to your name would create a taxable event.

The IRS would require that the S-Corp treat the property as if it had been sold at its fair market value. No one wants to pay taxes on phantom income!

7. You Haven’t Consulted with a Tax Professional

Choosing to have your business taxed as an S-Corporation is a big decision. It’s not something that should be taken lightly nor should it be done on a whim. It’s very easy to do and very difficult to undo (like a tattoo—but worse!).

Choosing to set up an S-Corporation based on indirect advice is akin to relying on WebMD for a medical diagnosis. You should consult with a tax professional who can examine your specific situation and help you make an informed decision.

Best Tax Structure for Your Business

An S-Corp can be a fantastic tool for small businesses but it can also wreak havoc if it’s not the ideal structure for your business. If you’re wondering if an S-Corp is the right structure for your business, feel free to contact us to set up a consultation today!