Choosing the right business structure is one of the most important tax decisions a small business owner can make. One option that is particularly popular among accountants, for better or for worse, is the S-Corporation. It’s either a tax-saving miracle or a Hell of your own making, depending on your situation.

I have spun up a few S-Corporations in my time, and I have killed a few. Some clients hear about S-Corps on TikTok and contrive the most complicated setups possible to ultimately pay more in taxes. For others, the S election makes a lot of sense; but they need to understand the consequences.

So, let’s break it down: What is an S-Corporation? Who can own one? Why would you want to be one?

Perhaps most importantly, why should you be afraid of S-Corporations?

What is an S-Corporation?

Despite the name, an S-Corporation isn’t actually a type of entity. It’s a tax status—a regular corporation (or LLC) that elects to be taxed under Subchapter S of the Internal Revenue Code using Form 2553.

In simpler terms, it’s a C-Corporation (or an LLC electing corporate treatment) that opts to be taxed like a partnership. An S-Corporation files its own tax return using Form 1120-S. Income passes through to shareholders via a Schedule K-1, allowing it to avoid corporate-level tax.

Shareholders receive stock basis, which is important for tax planning and determining whether distributions are taxable. While distributions of cash are generally tax-free if they fall within the shareholder’s basis, distributions of property are treated as taxable events.

Who Can Own an S-Corporation?

Not everyone can.

S-Corporation shareholders must meet specific eligibility requirements. They must be U.S. citizens or legal residents and must be individuals, though certain trusts or estates may also qualify. Partnerships and corporations are not permitted to be shareholders. The S-Corporation is limited to no more than 100 shareholders and can only have one class of stock.

If your ownership structure ever violates these rules—say, a shareholder sells stock to a nonresident alien—the S election is automatically revoked, and you’re back to being taxed as a C-Corp. This is why legal agreements are essential to protect the structure, especially for LLCs taxed as S-Corps. (Talk to your lawyer!)

Why Should I Be an S-Corporation?

There’s really one big reason: to avoid self-employment tax.

Sole proprietors and partners pay 15.3% in self-employment tax. By electing S-Corporation status, business owners can split their income into two parts: a reasonable salary and a shareholder distribution.

The salary portion is subject to payroll taxes, but the distribution portion is not subject to self-employment tax.

This structure can result in significant tax savings, especially as income grows. However, it’s essential to pay yourself a reasonable salary that reflects the work you do—if the IRS deems your salary too low, they can reclassify distributions and assess back taxes and penalties.

Why Should I Fear S-Corporations?

Here’s the other side of the coin. There are six major pitfalls you should be aware of:

1. Reasonable Compensation

You must pay yourself a reasonable salary if you’re working in the business. The IRS takes this seriously, and so should you.

Skipping this step is a red flag for audits. You can learn more about reasonable compensation here.

2. Qualified Business Income Deduction (QBID)

The QBID lets eligible taxpayers deduct 20% of business income.

But here’s the catch: W-2 wages don’t count as QBI.

The more you pay yourself as a salary (required for reasonable comp), the less you get to deduct under QBI. It’s a balancing act.

3. Reporting & Recordkeeping

S-Corps are subject to strict compliance and reporting requirements.

They must run payroll for any employees, including owner-employees, and file the appropriate payroll tax forms with both state and federal agencies.

Each year, the corporation must file Form 1120-S, which is due by March 15, and issue a Schedule K-1 to each shareholder to report their share of the company’s income, deductions, and credits.

In addition, S-Corporations are required to maintain accurate financial records, including a balance sheet and income statement that must reconcile with the tax return.

This isn’t a DIY tax job—it often requires professional help (and fees).

4. Property Distributions Are Taxable

If the business gives property (like real estate or equipment) to a shareholder, it’s taxed as if it was sold at fair market value.

As an example, let’s say that AB LLC, a multi-member LLC with an active S-Election is used to purchase real estate for $100,000. It is depreciated by $50,000 for tax purposes, but its fair market value increases to $300,000.

If AB LLC dissolves, reverts to a partnership, or distributes its real estate to one of its shareholders, it would generate $50,000 of depreciation recapture and $200,000 of capital gain, even if no cash changed hands!

5. Debt Basis

In partnerships, partners can take tax losses against borrowed funds. Not so in S-Corps.

Only direct shareholder loans count toward basis. If your S-Corp borrows money (even if you guarantee the loan), it doesn’t increase your basis.

In some cases, basis issues can arise right from the start. A client of ours had once made an S election while their LLC had more liabilities than assets on the books. Because of this imbalance, it was treated as though the newly formed S-Corporation assumed the shareholder’s personal debt, which triggered a short-term capital gain immediately. Not exactly the smooth start they were hoping for!

6. No Step-Up in Asset Basis

When a shareholder dies, the heir gets a step-up in stock basis, but not in the underlying assets of the corporation.

That means the company’s property retains its original basis, along with any depreciation schedules and tax consequences. This can create planning complications for heirs.

The S-Corp Question

S-Corporations work best for high-income individuals in professional service fields, such as consultants, attorneys, or medical professionals. They’re also a good fit for businesses with few shareholders and relatively simple ownership structures.

Owners who hold property personally and lease it to their S-Corporation can benefit from favorable tax treatment as well. Additionally, taxpayers who are phased out of the Qualified Business Income (QBI) deduction may use S-Corp W-2 wages to help phase the deduction back in.

On the other hand, S-Corporations don’t work well for businesses with little or no net income, as the compliance costs can outweigh the tax benefits. They’re also a poor fit for companies that own real estate or heavy equipment, due to the unfavorable treatment of property distributions.

Buying S-Corp stock instead of purchasing assets directly can complicate transactions and limit tax advantages. Lastly, S-Corps are generally unsuitable for businesses with passive investors who aren’t actively involved in operations, since shareholder activity can affect eligibility and basis issues.

Final Thoughts

The S-Corp can be a powerful tax planning tool, but it’s not a one-size-fits-all solution. It comes with compliance burdens, nuanced rules, and potential traps.

Before electing S-Corp status, ask your CPA: Is this the right structure for my business, right now and in the future?

At Bennett Accounting & Tax LLC, we help clients navigate this decision every day. If you’re unsure whether the S-Corp election makes sense for you, let’s talk.