An S corporation is a business entity that combines many of the advantages of an LLC with the advantages of a corporation. Practically, the biggest hurdle for someone looking to start a corporation is the problem of double taxation. That is, paying taxes for the activities of the corporation and also for profits that are distributed to the shareholders through dividends and stock appreciation. An S corporation eliminates this problem by “passing through” all profits and losses to the shareholders’ individual income taxes, rather than creating a separate layer of taxes for the corporate entity.
The primary advantage of an S corporation is that you accrue most of the benefits of corporate status without double taxation. LLCs are more flexible and require less corporate governance than LLCs, but it is easier to convert to a C corporation from an S corporation than from an LLC.
If you think that long term you want to be a corporation, but short term you expect to have losses, an S corporation might make sense for you. If you have losses in the first year and other income to offset those losses, the S corporation is a handy tool to write off any potential losses associated with the new business against income acquired through other means. Once you reach the stage where separate taxation makes sense, becoming an C corporation is as simple as “unchecking the box.”
The primary disadvantage of an S corporation is the limitation on types of shareholders. First, you can only have a maximum of 100 shareholders in an S corp. For most new and small businesses, this isn’t a problem. But, this could be an issue for businesses looking to raise money through crowdfunding. Second, only American citizens and permanent residents can own shares of an S corporation. Third, LLCs cannot own shares of an S corporation. This often prevents holding companies from owning S corporations. Last but not least, you can only have one class of stock, so no preferred shares.
The other significant disadvantage of an S corp is that it discourages the company from retaining earnings. For example in an S corporation, if a company earns a $100,000 profit and retains the earnings for later investment, the individual owners of the company are taxed on those earnings nonetheless. For a standard corporation, individuals pay taxes on dividends and capital appreciation. For companies where retained earnings are a significant part of your initial development strategy (again, not very common), s corporations probably don’t make sense.