According to the Internal Revenue Service, S corporations
now outnumber regular corporations and more than 350,000
new S corporations appear each year.
The popularity of S corporations should not surprise,
however. S corporations provide two big tax savings to
small business owners. First, they typically don't pay
federal or state corporate income taxes.
And, second, S corporations often minimize the payroll
taxes that S corporation shareholder-employees pay because
only amounts the corporation designates as wages get taxed
for Social Security and Medicare tax purposes.
Unfortunately, S corporation owners make some common tax
blunders--blunders that can destroy or delay the tax
savings the S corporation option should deliver.
Blunder 1: Late Sub S Elections
The first blunder? Thinking you can make the S election at
the end of the year. An S election needs to be made early
in the year or before the year even starts in order to be
effective for the year. Specifically, you should make the S
election either before the year starts or within 75 days
after the start of the new year.
For a business whose tax year begins on January 1, the
election needs to be made by March 15. If a new business
begins life mid-year on, say, May 23, the 75-day counter
starts ticking down from that date.
Note: The IRS does provide a mulligan for people who miss
the election deadline. Taking this mulligan, however,
requires that you strictly follow some "late S election
relief" procedures. Accordingly, you probably want to get a
CPA's help with this.
Blunder 2: Forgetting Shareholder-employee Payroll
When you make a successful S election, the Internal Revenue
Service sends your business an approval letter. That letter
uses scary--almost threatening language--warning you to pay
reasonable compensation to shareholder-employees.
Despite the warning, S corporations commonly forget to do
the formal payroll thing--including regular payroll checks
and tax deposits, quarterly payroll tax returns, and
year-end W-2s. That's often a huge mistake.
If you don't do payroll, the IRS will catch up with you. At
that point, the IRS will re-categorize all of the
shareholder-employee draws as wages. This re-categorization
may trigger thousands of dollars of back taxes, penalties
and interest for each year and for each
shareholder-employee for whom you forgot to do payroll.
Accordingly, you got to do payroll. Period.
Blunder 3: Bad Borrowing Habits
Ironically, your bank often helps you make another common S
corporation tax blunder: The bank will loan you money to
buy some piece of equipment--or perhaps a business vehicle.
But--and here's the mistake--the bank often loans the money
to your S corporation. Instead, the bank should loan the
money to you personally and you should then re-loan the
money to your S corporation.
An awkward problem exists when a business loan gets used to
fund an S corporation purchase. You only get to write off
the purchase price of the business asset if you have at
least that much basis in the S corporation. Yet you only
get basis from money you've personally invested in or
personally loaned to the corporation.
You don't get basis from a loan made to your S corporation
for, say, a new delivery vehicle purchased for the
business. Without basis, you often won't be able to deduct
the purchase on your tax return.
This S corporation tax mistake gets made all the
time--often when S corporation owners are making last
minute, year-end asset purchases to drive down their income.
Fortunately, you can solve the problem pretty easily. Make
sure you directly borrow the money for asset purchases and
then do a back-to-back loan to your corporation.
This back-to-back loan shouldn't increase your risks.
You'll probably have to personally guarantee the loan
anyway, right?
Blunder 4: Triggering the BIG Tax
Typically, S corporations don't pay federal income taxes.
That's a huge part of the attraction. However, two common
exceptions to this general rule exist for S corporations
previously operated as regular C corporations.
The first exception? The "built-in gain" or BIG tax. It
applies to profits recognized by the S corporation but
stemming from the time when the corporation operated as a C
corporation.
The details of the BIG tax get really tedious. But logic is
really simple. If you would have paid tax on some income or
gain had you still been a regular C corporation and that
income or gain was already "locked in" at the point you
converted from a C corporation to an S corporation, the old
C corporation tax (35% of profits) still applies.
The moral: You need to be really careful if you convert to
S corp status after operating as a C corporation. Make sure
your accountant understands and helps you minimize the BIG
tax.
Blunder 5: Passive Income Excesses
Another tax blunder threatens S corporations previously
operated as C corporations, too.
If an S corporation profitably operated as a C corporation
and has retained some of those profits, passive income
(interest, rents, dividends and so forth) gets taxed when
it exceeds 25% of gross receipts.
This excessive passive income problem may seem only
theoretical. But it occurs regularly with old S
corporations being wound down by the owners--say for
retirement.
If an S corporation that used to be a C corporation
metamorphoses from an operating company to an investment
company, at some point, the S corporation may pay corporate
income taxes.
If that isn't bad enough, yet another problem exists with
turning an S corporation that used to be a C corporation
into an investment holding company. If the passive income
crosses over the 25% threshold for three years in a row,
the S corporation status terminates.
Typically, because of the tax on excessive passive income
and the risk of S status termination, you want to avoid or
minimize passive income within an S corporation that used
to be a C corporation. One easy way to do this is to
distribute profits to shareholders rather than reinvest
them.
----------------------------------------------------
Stephen L. Nelson taught the S corporation tax class in
Golden Gate University's masters in taxation program and
edits the http://www.scorporationsexplained.com and
http://www.llcsexplained.com web sites.
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