Percheron Hill LLC: Small Business Articles

S Corporation Tax Blunders

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.

About the author:

Seattle tax accountant Stephen L. Nelson is also the author of online web resource that talks in more detail about S corporation taxation issues: