Operating a business as an S-Corporation offers significant benefits, especially in terms of taxation and liability. However, like any corporate structure, it comes with its own set of challenges. Based on detailed information from the S-Corporation Taxes and Credits document, this article will outline both the advantages and disadvantages of this entity structure to help business owners make an informed decision.

One of the most significant advantages of an S-Corporation is the pass-through taxation model. Unlike C-Corporations, where income is taxed at both the corporate and individual levels (double taxation), S-Corporation income is only taxed once, at the shareholder level. This provides substantial savings for shareholders, who report their share of income or losses directly on their personal tax returns.

This tax benefit is particularly appealing for small and medium-sized businesses seeking to avoid the complexities of corporate tax but still maintain a formal structure. However, the pass-through system does come with increased administrative responsibilities for shareholders.

One of the most critical tax considerations when converting from a C-Corporation to an S-Corporation is the built-in gains (BIG) tax. This tax applies to any appreciated assets held by the corporation during its time as a C-Corporation if they are sold during the "recognition period"—typically five years after the conversion.

While the BIG tax can be avoided if assets are held beyond the recognition period, businesses planning to liquidate or sell assets shortly after conversion should be aware of the potentially hefty tax burden.​

S-Corporations offer shareholders the opportunity to adjust their stock basis annually based on income and distributions. This adjustment provides an advantage when deducting losses from the corporation, as shareholders can use their increased basis to offset future gains.

However, S-Corporations are limited to a single class of stock, although they may offer both voting and non-voting shares. This restriction can be a drawback for businesses looking to attract diverse investors with different rights or interests.​

A significant advantage for S-Corporations is the ability to make tax-free distributions to shareholders up to the amount of their stock basis. These distributions are not subject to dividend tax rates, unlike C-Corporations, where dividends are taxed at both the corporate and shareholder levels.

However, S-Corporations must be careful not to have accumulated earnings and profits from their time as a C-Corporation. If the corporation has both earnings and significant passive income, it risks having its S-Corporation status terminated.​

S-Corporations offer several tools for estate planning, particularly with the use of trusts. Trusts such as Qualified Subchapter S Trusts (QSSTs) and Electing Small Business Trusts (ESBTs) allow business owners to transfer income from the corporation without giving full control to beneficiaries. These options provide flexibility for maintaining corporate governance while supporting beneficiaries financially.

A downside to estate planning with an S-Corporation is that some trusts may not qualify as S-Corporation shareholders, which can result in the automatic termination of S-Corporation status unless appropriate steps are taken.​

An S-Corporation can be penalized for having too much passive income (more than 25% of gross receipts) if it still retains earnings and profits from its previous C-Corporation status. If this passive income threshold is exceeded for three consecutive years, the S-Corporation risks losing its tax designation. This would result in the corporation being taxed at the corporate level once again, eliminating the primary tax advantage of an S-Corporation.

Businesses heavily reliant on passive income streams such as rental or investment income may find this rule a significant drawback, as it limits how they can structure their earnings.

S-Corporations present a valuable opportunity for businesses to reduce their tax burden through pass-through taxation while maintaining liability protection for shareholders. However, the limitations on shareholders, potential built-in gains tax, and the risks associated with passive income must be carefully considered. For small and medium-sized businesses that can navigate these challenges, the S-Corporation structure offers a balanced approach to taxation and growth.