S corporations provide big tax savings for small business owners. That explains the huge popularity of S corporations over regular corporations.
However, the S corporation provides the business owner many opportunities to make mistakes that can have a negative impact on their business; here are three common ones.
1. Late Sub S Elections
A business MUST send in paperwork to become an S Corporation. The S election MUST be filed within 75 days after the start of the new tax year. For most businesses, the deadline is March 15. (For a new business formed in the middle of the year, the 75-day counter starts ticking down from that date).
Many S corporation owners are not aware of this deadline and miss it.
IRS does provide a “late S election relief” procedure. Seriously, you probably want to get help from an informed tax professional if you seek this relief.
2: Neglecting Shareholder-employee Payroll
IRS repeatedly warns S corporation owners to pay reasonable compensation to themselves.
Despite the warning, S corporation owners often forget to put themselves on payroll–regular payroll checks with tax payments for withholdings, filing W-2s, etc. Instead, S Corporation owners pull out money as a draw. Big mistake!
You are at-risk for an IRS audit. IRS will recharacterize all those draws as wages. This recharacterization triggers punitive back taxes, penalties and interest. These audits have bankrupted the business and owner.
So, Mr. or Ms. S Corporation Ownerâ€”please pay yourself a reasonable compensation. If you are unclear what that means, find yourself a business tax accountant that does.
3: Bad Loan Structures
Banks are often the accompanist to this very common S corporation blunder: Banks often will loan you money directly to your S corporation to buy equipment, building, etc. Wrong move!
As odd as it sounds, have the bank loan you the money to you personally and then you loan the money to the S corp.
In order to take any losses of the S corporation, you must have at least that much basis in the S corporation. But you only get basis from money you’ve personally invested in or personally loaned to the corporation. Bank loans made directly to the S corporation do not count.
This S corporation tax mistake gets made all the time–S corporation owners have loans made to the S corporation but then canâ€™t take any deductions because there is no basis!
To add insult to injury, the S corporation loan is personally guaranteed or dual titled (loan made to both S corporation and person) and still no deduction.
What is basis?
Think of basis like a checking account. Investing in the business increase basis just like a bank deposit. A draw from of the business decreases basis just like a bank withdrawal. Profits of the business add to basis and losses of the business decrease from basis (similar to how interest earnings increase a bank balance and bank fees subtract from it). Just like a bank account, more basis cannot go out than comes inâ€”basis can never go below zero.
(Basis is a complex concept that deserves more explanation than the summary presented here).
Make sure you are working with an accountant that understands basis rules. He or she can help structure the loan with the bank so you get a tax write-off and avoid unwelcome surprises.
By: John J. Kasperek, Enrolled Agent.
John has been assisting business owners in his accounting practice for 25 years.