What Are the Two Main Disadvantages of an S Corporation?

If you reduce the long list of S corporation drawbacks to the two that actually decide whether the election fits your business, they are these: the rigid ownership and eligibility rules, and the salary-plus-compliance obligation that comes with paying yourself properly. Almost every other complaint about S corps is a downstream consequence of one of these two. Get clear on both and you can tell, fairly quickly, whether the election is a tool or a trap for your situation.

These two disadvantages pull in different directions, which is part of what makes them important. The ownership rules limit who is allowed to be involved and how the business can grow. The salary-and-compliance burden limits how much the election actually saves and how much work it takes to maintain. One is about your future. The other is about your present. A business can be a good S corp candidate on one axis and a poor one on the other, and you need to evaluate both before you file Form 2553.

Disadvantage One: The Ownership Rules Are Rigid and Unforgiving

The first main disadvantage is that an S corporation can only exist within strict boundaries set by IRC § 1361, and those boundaries collide directly with the way ambitious businesses tend to grow. To qualify as a small business corporation eligible for the election, you cannot have more than 100 shareholders, every shareholder must be a U.S. citizen or resident individual (with narrow exceptions for certain trusts and estates), you cannot have a corporation or partnership as an owner, and you are limited to a single class of stock.

Each of these is a wall that a growing company tends to run into. The one-class-of-stock rule under IRC § 1361(b)(1)(D) means you cannot offer investors preferred equity with a liquidation preference, which is exactly the instrument most outside investors expect. The citizen-or-resident requirement means a single foreign co-founder or investor disqualifies the entire election. The no-entity-owners rule means a venture fund, a holding company, or another LLC simply cannot be on your cap table. For any business that intends to raise priced equity or build a sophisticated ownership structure, the S corp is not merely inconvenient. It is incompatible.

What makes this disadvantage genuinely dangerous is that the consequences are automatic and retroactive. Under IRC § 1362(d)(2), the S election terminates on the day an ineligible shareholder appears or a second class of stock is created. There is no warning and no grace period. The business reverts to C corporation taxation as of that date, and cleaning up the mess requires inadvertent-termination relief from the IRS that you might not get. The election that saved you self-employment tax for years can vanish the moment you accept the wrong investor, and you may not realize it happened until the tax bill arrives.

Disadvantage Two: The Salary Requirement and the Compliance That Follows

The second main disadvantage is that the S corp's tax benefit is gated behind the reasonable compensation requirement, and capturing it forces you to build and maintain payroll infrastructure you would otherwise never need. The savings come from taking part of your profit as distribution rather than salary, because distributions escape the 15.3 percent self-employment tax. But you cannot simply minimize the salary. The authority interpreting employment tax, reflected in rulings like Rev. Rul. 74-44 and cases like David E. Watson, P.C. v. United States, requires that your salary reflect reasonable compensation for the work you actually do.

This requirement does two harmful things at once. It caps your savings, because the larger your defensible salary, the smaller the distribution that sits outside the tax. And it imposes uncertainty, because reasonable compensation is a multi-factor judgment that the IRS can revisit years later with hindsight. Pay yourself too little and the IRS can reclassify distributions as wages under IRC § 3121, adding back payroll taxes, penalties, and interest across multiple open years. The downside of guessing wrong is far larger than the upside of guessing aggressively.

To support that salary, you must run real payroll: quarterly Form 941 filings, payroll tax deposits, a year-end W-2, and a separate Form 1120-S corporate return. That is a payroll service, higher accounting fees, and ongoing administrative time, none of which a default LLC or sole proprietor carries. In California, the burden grows heavier still, because the state imposes a 1.5 percent franchise tax on S corp net income under California Revenue and Taxation Code section 23802, with an 800 dollar annual minimum, that a single-member LLC taxed as a disregarded entity does not pay. The compliance cost and the California tax together are why the election rarely pays off below roughly 40,000 to 60,000 dollars of net profit.

Why Both Disadvantages Have to Be Weighed Together

These two disadvantages are not redundant, and a business can fail either test independently. A profitable solo professional with a clean ownership structure passes the first test easily, because the rigid eligibility rules never bind a single-owner business. But that same professional can still fail the second test if a reasonable salary for their high-value work consumes most of the profit, leaving little distribution to shelter and barely justifying the compliance cost. The ownership rules are fine. The economics are thin.

The reverse happens too. A scalable startup might have plenty of profit and a large potential distribution, which makes the second disadvantage easy to absorb, but its plan to raise venture funding from institutional investors runs straight into the first disadvantage. The economics work. The ownership rules do not. For that company, the S corp election is a structure it will have to unwind the moment it raises a priced round, which makes electing it in the first place a mistake.

A short example shows how the two filters operate independently. Imagine two California businesses, each netting 220,000 dollars. The first is a solo design studio owned by one citizen with no plans to raise capital; it sails through the ownership filter, and with a reasonable salary of 95,000 dollars it has a large distribution to shelter, so it clears the economic filter too. The S corp is an easy yes. The second is a venture-track software company with the same profit but a foreign technical co-founder and a term sheet that contemplates preferred stock; the economics look identical, yet the ownership filter fails outright, because the foreign owner and the preferred class each independently disqualify the election under IRC § 1361. Same revenue, opposite conclusions, decided entirely by which filter binds. That is why naming the two disadvantages separately is not academic. It is how you avoid electing into a structure your own plans will force you to dismantle.

So the two main disadvantages of an S corporation function as two separate filters. The ownership and eligibility rules ask whether your business can stay inside the S corp boundaries through its planned growth. The salary and compliance burden asks whether your numbers make the savings worth the cost and the audit exposure. The election is a good idea only when a business clears both filters, and the most common planning errors come from owners who checked one and forgot to check the other. The owner who modeled the tax savings but never stress-tested the cap table, and the owner who confirmed clean ownership but never ran the salary math, make the same mistake in mirror image. Both treated a two-part question as if it had one answer. The discipline that protects you is simply refusing to file Form 2553 until you can speak to both the ownership filter and the economic filter for your own business, in your own words.

Related reading: the disadvantages of an S corporation, what is a disadvantage of an S corp, the downside of being an S corp, which is best, LLC or S corp. For the full practice overview, see our S-Corp Attorney page.

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The two main disadvantages of an S corporation are exactly the two questions worth answering before you file, and both depend on facts a calculator cannot see: your growth plans and your real compensation picture. Delina helps founders weigh both against the specifics of their business.

If you're ready to test the S corp election against your ownership plans and your numbers, book a paid intake with Delina. This is not a free call. It is a focused, strategic session with an attorney who has read everything above and has specific opinions about your situation.