Why an S-corp may not make sense for your business

By now, we've all heard that S-corps offer great tax savings for business owners; and while that can be true, it's also important to understand that there are factors that can sometimes make the S-corp a less-than-ideal option. In this article, we'll discuss certain elements of s-corporations that may not make it the best fit for your business.

1. Ownership Restrictions and Eligibility Rules

First of all, S-corps cannot have more than 100 shareholders. There are strict limitations on who can be an eligible shareholder (e.g., no partnerships, corporations, or nonresident aliens). This precludes entities seeking broad or non-individual ownership structures, or those anticipating nonresident participation, from qualifying. Additionally, only one class of stock is allowed, limiting options for differentiated equity structures.

There is nuance here as family members are treated differently under this count. If you plan to have family members as owners of the business, you need to plan with a tax professional.

Impact: Failure to comply with these rules can lead to automatic termination of S-corp status, which can have adverse tax consequences.

2. Compliance Costs and Administrative Complexity

The S-corp structure demands more rigorous compliance than sole proprietorships or basic LLCs. For example, S-corps must file Form 1120-S, maintain payroll for shareholder employees and ensure “reasonable compensation” is paid per IRS guidance.

Reasoning: Establishing and maintaining payroll, keeping formal records (including annual meeting minutes), and filing separate business tax returns create ongoing compliance burdens and professional fees. These requirements are non-negotiable to maintain S-corp status per the Internal Revenue Code and IRS form instructions.

Impact: Businesses without sufficient profits may see compliance costs wipe out any tax benefit from S-corp election, especially if taxable income falls below practical thresholds. Administrative complexity is not offset by tax savings for low-profit or early-stage businesses.

3. Potential Pitfalls with Basis and Distributions

S-corp shareholders may only receive distributions tax-free to the extent of their stock basis. Distributions exceeding basis are taxed as capital gains. In addition, loss deductions are limited to stock and debt basis.

Reasoning: Failure to monitor basis calculations or making distributions in excess of basis can trigger unexpected tax liabilities. The complexity is compounded as S-corps must track basis at the shareholder level and maintain rigorous records to avoid adverse tax events.

Impact: Errors in basis tracking or “excess distributions” could result in underreported income, leading to IRS assessments of tax, penalties, and interest under statutory authority.

So essentially, an S-corp is much more than just checking a box on Form 2553. It entails a commitment to complying with strict requirements and ongoing investment in the administrative fees required to properly maintain it.

If you’re a Maryland business owner evaluating an S-corp election, these statutory considerations are critical. Each business is unique, and errors in S-corp compliance can be costly. Contact Aventa Tax—Maryland’s trusted advisor for S-corp tax planning—to ensure you maximize your tax outcome, remain compliant with state and federal law, and make the best structural choice for your business’s future. Learn more about S-corporation Tax Services here

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