15 Major Disadvantages of S Corps: When NOT to Become an S Corp

By Sherman Standberry, CPA

The S-Corporation tax status has become so glorified that taxpayers elect it without fully understanding it.

Most people are curious about the following:

Will my company be eligible for S Corp status?
Do I have a tax pro to help navigate S Corp taxation?
When must shareholders/employees pay themselves wages?
Can I use an S Corp for real estate investing?
What’s the process for electing S Corp status?

However, what you should really be asking is:

Is an S Corp the best structure for my business?

This critical question trips up many entrepreneurs. While S Corps tout valuable benefits like self-employment tax savings, there are some serious drawbacks as well.

In this blog post, we’ll examine 15 major (hidden) disadvantages of S Corps you need to know before electing S Corp status.

It looks at burdensome compliance rules, payroll tax traps, state taxes, administrative headaches, and more that can diminish benefits.

The goal is to help you make the smartest decision for your business.

But first, let’s address the elephant in the room – why most taxpayers elect S-Corp status.

The main benefit of becoming an S Corp

The largest benefit of an S Corp is avoiding 15.3% self-employment tax on all business income.

So instead of paying self-employment tax on 100% of business income, you’d only pay it on W-2 wages from the S Corp.

As a W-2 employee, technically you have zero self-employment tax. You pay social security and Medicare taxes — effectively the same thing.

The only real difference is you’re only paying these taxes on wages, not your total income.

So the main tax strategy is reducing the amount of self-employment tax you pay.

For example, instead of $15,000 (15%) tax on $100,000 business income, you’d pay $6,000 (15%) on $40,000 wages. No self-employment tax on the remaining $60,000 profits.

In this example, you would save about $9,000 in taxes via an S Corp. That’s exactly why thousands of entrepreneurs make the switch to an S Corp.

The IRS estimates over 5 million S Corporations in the U.S. — three times the number of C corps.

The S-Corp status is great if the savings outweigh the extra cons, rules, and costs of being an S Corp.

But what if they don’t?

We’ll be covering these problems in detail in this post.

So let’s get started and dive into the disadvantages of becoming an S Corporation.

Disadvantage #1: Not Making Enough Taxable Income

Many tax professionals give cookie-cutter advice: Become an S Corp when you earn over $40,000.

Their logic? At that income, self-employment tax exceeds $6,000, so it covers the S Corp transition costs.

The issue is most business owners don’t know their actual taxable income.

Taxable income is what is left after deducting all expenses. Not the same as revenue.

A lot of business owners forget to factor in their income after all business tax deductions, which may make the S-Corp unnecessary.

Ideally, your taxable income should hit $40,000+ after deductions. And even then, some CPAs recommend aiming higher.

But here’s a crucial point that most do not consider…

What if you’re missing deductions to lower taxable income even more?

Let’s say your taxable income is acceptable for an S-Corp, but you are missing several deductions.

If you are missing deductions, that means that your taxable income could be lower.

It could be so much lower that an S-Corp may become unnecessary.

So before jumping to an S Corp, first hunt for deductions to shrink taxable income. Entity change should come later.

When we consult clients on tax planning, we almost always uncover tens of thousands in extra deductions before we consider an entity switch.

Disadvantage #2: You already have W-2 Income

Remember, self-employment tax equals the social security and medicare taxes paid as an employee.

So if you already earn income subject to these taxes, the S-Corp status may be less beneficial for you.

This is because a big portion of these taxes share the same maximum limit — $160,000 as of 2023.

And after you hit the maximum limit, the amount of those taxes decreases significantly.

Which means if you already have significant W-2 income subject to social security and medicare taxes, you may not be subject to as much self-employment tax from your business.

Let’s break it down.

First off, only social security tax hits this wage limit.

Social security tax is 12.4% up to the limit. Medicare tax is 2.9% on all earned income indefinitely.

So even if you earn over the limit, you still owe 2.9% Medicare tax. Plus a possible extra 0.9% if income exceeds $250,000.

The upshot: S Corp tax benefits decrease if you already have substantial W-2 income paying social security and Medicare taxes.

For example, say you have $160,000 in business income, and $160,000 in W-2 wages too.

Since your W-2 income covers social security tax, your business income skips the 12.4% rate.

Instead, you’d only pay 2.9% Medicare tax on the $160,000 business income — around $4,600.

Without the W-2 income, self-employment tax on the $160,000 would exceed $24,000. The extra 12.4% social security tax would now apply to your business income.

$24,000 saved versus $4,600 saved — big difference. So factor W-2 income when weighing an S Corp move.

And yes, even with an S Corp, you’d still save that $4,600 Medicare tax.

But make sure you weigh that versus everything else an S Corp brings.

Disadvantage #3: Disparity among Multiple Business Partners

If you’re a solo business owner, skip ahead to the next point in this post.

But if you have partners, pay close attention.

Having multiple active S Corp shareholders can get “messy” depending on the circumstances.

Let’s start with how multiple partners contrast in an LLC vs. S Corp.

Multi-member LLCs have more flexibility distributing profits. Like two 50-50 LLC partners can split profits unevenly if they want.

For instance, if one LLC partner generates more revenue in a year, their agreement could award them a bigger profit share.

So instead of 50/50 profits, maybe it’s 60/40.

But S Corp, on the other hand, lacks that flexibility. Profits must be split based on your ownership share in the business.

You can’t set up income-split agreements on profit distribution to shareholders.

It’s the same for expenses too.

For instance, what if one partner buys a $50,000 vehicle themselves, uses it for the business, and wants to deduct it?

Sure, they can deduct it through the S Corp but must share the deduction with partners—even if those partners did not personally pay for this expense.

So the partner who bought it with their own funds may dislike splitting the deduction with partners who paid $0.

It’s the same for other write-offs too — home office, travel, meals, health insurance, and other reimbursable expenses.

Those deductions get shared even if some shareholders didn’t contribute to those expenses.

So when some partners bring more revenue or deductions, splitting the benefits in an S Corp can be problematic.

A Popular Solution:

Instead of creating a joint S-Corp with multiple shareholders, you could keep the LLC.

Then you could have each partner create their own S Corp.

Each partner’s S Corp then owns a share of the multi-member LLC. So on paper, it’s run by the S Corps, not directly by the partners.

This way, each owner fully benefits from deductions and strategies in their own S Corp.

And they have maximum control (and flexibility) over their own pay.

Disadvantage #4: Limited Contributions to SEP IRAs and Solo 401K Accounts

As a solo self-employed person, you are able to leverage powerful retirement accounts.

Namely, the SEP IRA and Solo 401k.

These accounts allow you to contribute up to $66,000 in 2023.

And your contributions are deductible, lowering taxable income on your tax return.

However, employer contributions are capped at 25% of your compensation as an employee.

That “employee” part is key.

When you’re not a corporation, 100% of your business income is considered personal income.

But as an S Corp, your W-2 salary counts as compensation.

Which means that your contributions would be limited to your W-2 salary, which is likely lower than your business income.

For example, if your business earns $200,000 and you take a $60,000 salary, you could only contribute 25% of $60,000, around $12,500.

Which means switching to an S Corp limits your contribution by over $37,000. Now you only contribute 25% of salary, instead of all your income.

So if you plan to max these accounts out, know that an S Corp switch may limit this tax deduction.

For our clients, we weigh the net benefit of an S Corp switch versus other tax strategies that could save more in taxes.

Disadvantage #5: Added payroll taxes when hiring your kids

So another popular tax strategy for business owners is hiring your kids.

The idea: Paying your kids (from your business) creates a tax deduction and lowers your income.

And if the kid earns under the standard deduction, they would effectively pay zero income tax.

When you’re the parent employing your child, the IRS says:

Payment is subject to income tax (but if under the standard deduction, they won’t owe tax since the deduction erases all income)
Payment is NOT subject to social security and Medicare taxes — (this is big, more on this later)
Payment is not subject to Federal Unemployment tax

With an S Corp, there’s one big difference: Payment is subject to social security, Medicare, and unemployment taxes.

So if you pay your child the 2023 standard deduction of $13,850, they’d pay around $2,100 in these taxes.
Without an S Corp, you’d pay none of those taxes.

There are several creative solutions to this problem:

#1. Choose not to elect S Corp status, avoiding the extra taxes

#2. Choose to elect S Corp since federal tax savings may still outweigh the extra taxes

#3. Elect S Corp status but create a family management LLC that services the S Corp, avoiding social security taxes

#4. You may want to get a custom analysis from mycpacoach.com (what I’d do!)

Disadvantage #6: Owning rental property

It normally does not make sense to own rental property through an S-Corp.

Here’s why: Passive rental income isn’t subject to self-employment tax.

This is important to understand, because if the goal of an S Corp is self-employment tax savings, and your rental income skips the tax anyway, there’s likely no benefit to switching.

Therefore, owning rentals through an S Corp is normally a bad move.

You’d just end up with more rules, requirements, and admin for minimal tax savings when compared to operating as an LLC.

For example, let’s say you currently own rental property in an LLC.

If you switched that to an S Corp, you’d have to follow more complex rules and file extra paperwork, even though your passive rental income doesn’t trigger self-employment tax in the first place. So there’s no advantage.

Disadvantage #7: Moving Assets Out of an S Corp

With an S-Corp, you and the business are separate entities.

Because of this, transferring assets from your business to you personally is more complicated.

If you are not careful, you can trigger capital gains tax.

This is because when you transfer assets from one entity to another (you), the IRS sees it as the business liquidating assets and distributing value.

For example, if you bought a car for $100k through your S-Corp, your cost basis would be $100,000.

Let’s say the car was worth $200,000 at a later date. And at that time, you distributed it from the S-Corp to you personally.

Here’s what would happen:

The IRS would see a $200,000 asset transfer from biz to shareholder, even with no cash.
You’d likely owe capital gains tax on the $100,000 value increase over your $100,000 basis.

Whereas without a corporation, you and your business are one entity.

Since property bought for your unincorporated business is already tied to you, there are fewer hoops to jump through.

Therefore, if you plan to acquire lots of assets through your S Corp – equipment, devices, vehicles, etc. — be mindful of the potential tax implications.

Disadvantage #8: Paying yourself too much from the S Corp

Yes, you can pay yourself too much as an S Corp. If so, you may owe more taxes.

As if it wasn’t complicated enough already!

According to the IRS, S-Corp shareholders must calculate something called stock and debt basis to avoid owing extra taxes on distributions.

Basis refers to the amount of cash or property you initially contribute to the business. It works similar to buying stocks:

When you first buy stocks, your basis is the purchase price.
If you buy more stocks at the same price, your overall basis increases.
If you later sell the stocks for a gain, you pay tax on the amount exceeding your basis.

The same principle applies when an S-Corp pays out profits to shareholders. If shareholders receive distributions exceeding their basis, they may owe capital gains taxes.

Here’s a simple example:

Say you contribute $5,000 of your own money to your business, giving you a $5,000 basis.

And your business ends up earning $45,000, effectively increasing your basis to $50,000.

But the business somehow pays you $55,000 in distributions, decreasing your basis to negative $5,000.

The excess $5,000 will be taxed as a capital gain.

To avoid such problems, you may want to keep your basis in mind when distributing S Corp funds.

Or don’t become an S Corp altogether, since disregarded entities are able to bypass these rules.

Disadvantage #9: Deducting Losses

With an S-Corp, your ability to deduct business losses is limited to your basis in the company. This differs from sole proprietorships and other pass-through entities.

Basis refers to your capital contributions and proportionate share of income. It determines how much you can deduct in losses.

For example:

Let’s say you have a $5,000 basis in your business.

And your business lost $7,000 this year.

Since it’s a business loss, it decreases your basis rather than raising it.

The IRS only allows losses against basis, so you could only claim a $5,000 loss on your return.

The remaining $2,000 loss gets suspended and carried forward indefinitely.

Again, the use case of S Corps is to avoid self-employment tax on income.

If you’re expecting a loss, you’d have no income and pay no tax anyway, which makes the S Corp useless.

Not profitable but considering an S Corp? Think again.
Already an S Corp expecting a loss? Understand how it impacts you.

Moving on to our next one…

Disadvantage #10: Unsure about the longevity of your business

If you’re unsure about business longevity, an S Corp can complicate things.

First, setting up an S Corp can be a hassle.

Secondly, exiting an S Corp can be a bigger headache.

You’d have to revoke S status, file a final return, close payroll accounts, dispose of assets in the S Corp triggering taxes, etc.

All to avoid a tax you may not even owe if you’re not highly profitable.

Bottomline: You may want to carefully consider if your business is serious enough or just a temporary side hustle for extra money.

Disadvantage #11: You do not like following the rules

S-Corp rules aren’t super complex, but there are rules.

You must set up payroll and pay yourself a reasonable salary the IRS could contest.

On that payroll, you must pay and file payroll tax returns.

You would also need to file an S Corp return separate from your personal one.

And when doing the return, you must know each shareholder’s basis…

Not to mention that you are supposed to have annual board meetings with shareholders. And keep minutes from those board meetings…

Oh, and you can’t have over 100 shareholders.

The list goes on and on.

If that stresses you out, you may want to think twice about becoming an S Corp.

Disadvantage #12: More expensive tax returns & accounting costs

Due to the complexities of an S Corp, expect to pay your CPA way more for an S Corp return — Firms often charge $1,500 to $3,000+ for it.

Plus, you’ll need a payroll system to file returns and submit withheld taxes – may cost you another $200-300+ per year.

And remember, you’re still paying payroll tax on your own salary.

So know these extra S Corp costs, and weigh them against potential savings.

Disadvantage #13: The word “payroll” makes your skin crawl

Setting up payroll is simple if you know what you’re doing, but can be stressful if you do not.

So consider if you don’t mind the added headache.

You’ll have to choose a provider, set up state accounts, add yourself as an employee, pay salary, and keep up with tax obligations.

Ultimately, decide if you want to deal with the payroll complexities or not.

Disadvantage #14: Additional State Taxes

Most states don’t levy extra S Corp taxes, but some do.

If yours does, it can pile the S Corp expenses.

For instance, California, New York, and Tennessee tax S Corps additionally. This isn’t an exhaustive list — so make sure to research your state.

If they do, factor it into your decision to become an S Corp.

Disadvantage #15: You care about having social security benefits when you retire

This matters because S Corps are used to avoid self-employment tax — which is a combination of your medicare and social security contributions.

If you pay little social security tax, you could get less benefits upon retiring.

You may not qualify for benefits anyway, but it doesn’t hurt to keep this in mind.

You could ask your CPA for a salary recommendation that avoids self-employment tax while optimizing social security benefits.

Conclusion

The S Corp entity offers valuable tax benefits for some, but also notable drawbacks and complexity that can outweigh the tax perks in many cases.

Before rushing to become one, analyze your situation closely — income, expenses, assets, goals, admin tolerance. See if it truly fits your needs.

Closely compare an S Corp vs an LLC for your business.

Ultimately, structure to maximize benefits and minimize headaches and costs.

Don’t let potential tax reduction lead to an entity that creates more problems than it solves. Weigh all key factors to make the smartest decision for you.