The Disadvantages of S Corporations: When Not To Become An S-Corp

By Sherman Standberry, CPA

This article is Tax Professional approved 

The S-Corporation tax status has become so glorified that taxpayers elect it without fully understanding it. To their surprise, there are several disadvantages of forming an S-Corporation. Anyone considering an S-Corporation should review the disadvantages to avoid additional costs and headaches in the future.

This post examines the top 15 S-Corp disadvantages. As CPAs, we see too many business owners fall victim to these drawbacks:

Table of Contents

You will learn the burdensome compliance rules, payroll tax traps, state taxes, administrative headaches, and more that can diminish the benefits of S-Corp.

But first, let’s address how you arrived here – why most taxpayers elect S-Corp status in the first place.

The main benefit of becoming an S Corp

The primary benefit of an S Corporation is that it is not subject to the 15.3% self-employment tax on all business income. Shareholders of S-Corporations do not pay self-employment tax on business profits.

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Instead, the IRS requires shareholder-employees to take W-2 wages, which are subject to employment tax.

Example: Let’s say your business earn $100,000 in income as an LLC. You would pay a $15,300 (15%) self-employment tax.

The difference is that you would only pay tax on your W-2 wages from the S Corp, as opposed to 100% of business profits. This typically results in 50-70% less employment tax.

But lets say you are an S-Corp with the same amount of income, and you take a $40,000 W-2 salary. In this case, you would pay $6,000 (15%) on $40,000 wages. And 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. And this is exactly why millions of entrepreneurs make the switch to an S Corp.

However, there are several rules and requirements that make S-Corporations less attractive. Many business owners are unaware of the following S-Corp disadvantages.

Disadvantage #1: Not Making Enough Taxable Income

If your business is not earning enough income, the costs of an S-Corporation may outweigh the benefits.

Many tax advisors believe that business income should exceed $40,000 before considering an S-Corporation.

At that income level, it is believed that your tax savings are expected to exceed the costs associated with the S-Corporation (more on this later).

However, the first issue is that many business owners do not know their actual taxable income.

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

Your business may earn over $40,000 in sales. But, if your actual taxable income is much less than this, an S-Corporation may be unnecessary.

In addition, many miss business tax deductions that can reduce their taxable income. Therefore, it is advisable that business owners ensure that they are maximizing all available deductions to reduce their income before switching to an S-Corp.

After-all, the dreaded self-employment tax is all based on your business income. If tax deductions reduce your income to almost nothing, you would pay almost no self-employment tax.

And by the way, 90% of business owners miss tax deductions… 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 — $168,600 as of 2024.

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.

To fully understand this concept, you must understand that the 15.3% self-employment tax is comprised of a 12.4% social security tax and a 2.9% medicare tax.

The 12.4% social security tax is only assessed on up to the limit of $168,600.

The 2.9% medicare tax, on the other hand, is taxed 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.

Therefore, if you income is above the wage limit, the S-Corp may save you at least 2.9% of your income in taxes.

If you are faced with this circumstance, consult with a tax advisor to run a thorough analysis.

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

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

It’s the same for expenses too.

But S Corp, on the other hand, lacks that flexibility. Profits must be split based on your ownership share in the business. This can become problematic when shareholders run various tax deductions through the entity.

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For instance, what if one partner buys a $50,000 business vehicle, with their own capital, and wants to deduct it?

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

Similar problems may arise for tax 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.

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 $69,000 as of 2024.

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, only 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.

Example: If your business earns $200,000 and you take a $60,000 salary, you would only be able to contribute 25% of $60,000, around $12,500.

Whereas if you were not a corporation, you could contribute $50,000. In this example, switching to an S Corp limits your retirement deduction by $37,500!

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:

  1. Payment is subject to income tax
  2. Payment is NOT subject to social security and Medicare taxes — (this is big, more on this later)
  3. 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 2024 standard deduction of $14,600, you would pay about $2,230 in additional taxes.

Without an S Corp, you’d pay none of those taxes.

Possible Solutions:

#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. Hire a CPA to help you determine the best approach

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.

In some rare instances, rental income is considered ordinary income. For example, if you are a real estate professional or have short-term rentals, the income may be considered ordinary income.

In those instances, an S-Corporation may be helpful. Though, it is very rare.

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 may 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.

It’s similar to selling stocks. When you sell a stock for a gain, you pay capital gain tax.

In the same way, assets the S-Corp distributes to you may also be considered a capital gain.

Whereas without a corporation, you and your business are considered one entity for tax purposes.

Any business assets you purchase is already tied to you. In other words, 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. We see many new S-Corps make this mistake.

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

In simple terms, basis refers to the amount you’ve contributed to the S-Corp plus any income the business earns.

When you receive distributions from the S-Corp, it lowers your basis.

And your basis becomes negative, you may be subject to additional capital gains taxes on those distributions.

In the eyes of the IRS, you are receiving distributions that are not a result of your business profits – so where are they coming from?

In most cases, shareholders miscalculate their basis. In other cases, they mistakenly distribute business assets to shareholders.

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 Are Limited

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.

If you incur a business loss through your S-Corp that exceeds your basis, the excess will be carried forward.

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.


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.


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