An S-corporation may not be right for your business

Many small business owners are told they should make the election to become an S-corporation. Often, this election does make sense, but here are some reasons why an S-corporation may not be best for you.

One of the requirements of an S-corporation is that there can be only one class of stock. If you are trying to attract some additional funding and wish to offer something such as preferred stock, this could be an issue. Another rule of an S-corporation is that there can only be 100 or less shareholders and all owners must be US citizens. They cannot have shareholders that are other companies such as corporations or partnerships.

S-corporations have to allocate income and losses to shareholders based on a per shareholder per day allocation (IRC 1377(a)). IRC Section 1366 does not allow for there is no flexibility to this as there are with other entity types.

A new member contributing property to an S-corporation may have to recognize gain on that property as if the property were sold to the S-corporation. Under IRC Section 351, there can be a tax-free exchange for stock to a corporation, but only if the individual(s) who transferred the assets become immediately in control after the transfer. Control is defined in IRC Section 368(c) as owning 80% or more of the voting stock.

S-corporation owners basis consists of what they have contributed to the company, plus their share of income or loss and minus what they have taken out of the company. Partnerships on the other had also can take advantage of entity level debt that they have helped secure to add to their partnership basis. This could allow partners to use leverage and deduct losses much greater than the amount of capital they have contributed.