S Corporation Tax Blunders
by Stephen L. Nelson
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.
Author and tax accountant Stephen L. Nelson is an adjunct tax professor teaching S corporation tax law at Golden Gate University. He also edits the S corporation and limited liability corporation web sites.
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.
Author and tax accountant Stephen L. Nelson is an adjunct tax professor teaching S corporation tax law at Golden Gate University. He also edits the S corporation and limited liability corporation web sites.
posted by Paul Wilczynski at
6:27 AM
1 Comments:
Most entrepreneurs need to borrow money at some point. When you’re in the market for small business financing, determining what kind of loan you can qualify for is the first step. Thanks for the info!
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