9 Things You Need to Know Before You Start an S-Corp
Turning your business into a S-Corporation can provide huge tax advantages, but not so fast! Take it slow and consider the costs and extra responsibility involved in electing your business to be taxed as an S-Corpration.
S-Corporations are tax elections of entities already created
S-Corporations aren’t entities, they’re merely regular business entities (such as LLCs) that have elected to be taxed under a certain set of rules of the US’s tax code (aka S-Corporation Rules).
Only certain types of entities are eligible for the S-Corporation tax election. Generally, eligible entities include domestic corporations, domestic limited liability companies (LLCs), and certain types of domestic partnerships.
Foreign business entities are not eligible for the S-Corporation tax status and generally foreigners are not eligible to own entities that have selected the S-Corporation tax status. There are other limitations to S-Corporations as well such as they’re only allowed to have up to 100 owners, and they can only have one (1) class of stock.
S-Corporations Require Detailed Tax Returns to be Filed
Typical small business tax returns only have to report revenue, expenses, and simply use those two numbers to calculate the profit left over (which is then taxed).
S-Corporation tax returns are required to report:
Income
Expenses
Profit
Assets, Liabilities
Owner Distributions
Owner Contributions
Owner’s Basis
Generally the fees to prepare an S-Corporation tax return are $2,000+
Be sure to take extra fees into account when choosing to elect your business entity to be taxed an S-Corporation.
Don’t get us wrong, the tax savings from S-Corporations might be totally worth it (and then some), but carefully consider these details before having your business entity elect to be taxed as an S-Corporation
Bookkeeping for S-Corporations must be completed in a strict fashion
Since S-Corporations require detailed tax reporting (as mentioned above), their bookkeeping must be more strictly maintained.
For smaller and simpler businesses, generally the goal for bookkeeping and tax reporting is to have an accurate P&L aka Income statement (Revenues - Expenses = Profit).
With S-Corporations balance sheet items, owner distributions and owner contributions will also need to be accurately accounted for.
Increasing complexity in the area of bookkeeping can increase the cost of this service. Generally bookkeeping for an S-Corporation starts out at a minimum of $500 per month.
Keeping detailed bookkeeping records can add an additional $3,000 to $30,000+ per year depending on the circumstances. Be sure to take these extra fees into consideration when choosing to elect your business entity to an S-Corporation.
S-Corporations Don’t Pay Taxes, They Pass Their Tax Liability to Their Owners
Although S-Corporations file a separate tax return, they are still pass-through entities for federal income tax purposes.
This means that the S-Corporation itself does not pay federal income tax on its profits.
Instead, the income or loss is "passed through" to the shareholders, who report it on their individual tax returns. There’s always exceptions to this rule so be ready to pay taxes to certain states. (I’m looking at you California)
Since S-Corporations are pass-through entities, once the S-Corporation tax return is completed, each owner will receive a K-1 which may complicate their personal tax return as well.
If you’re the owner of a pass-through entity (such as S-Corporations or Partnerships) make sure to not file your personal tax returns until you have received all K-1s that are due to you for that particular tax season.
Distributions from S-Corporations are restricted
One selling point of S-Corporations is the shareholders' ability to receive tax-free distributions.
S-Corporations must generally make distributions (or owner draws) to shareholders on a pro rata basis.
This means that distributions should be proportional to each shareholder's ownership percentage in the company.
This requirement stems from S-Corporation only being allowed to have one (1) class of stock.
If one owner gets a distribution, all owners must receive a similar distribution in proportion to their ownership percentage.
Shareholders' ability to receive tax-free distributions is subject to their basis in the S-Corporation being positive. Shareholders who do not have a positive basis in their company will have their distributions taxed at the capital gains tax rate.
Since S-Corp distributions must be completed on a pro rata basis you may need to update the operating agreement of your entity to reflect this restriction. If your entity’s operating agreement doesn’t conform to all s-corporation rules, regulations or restrictions the S-Corp tax status of your entity may be revoked by the IRS which would potentially cause the owners of this entity to face a large amount of penalties.
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Need advice in the area of S-Corporation taxes or accounting?
Click the link below to schedule a call with the founder, Jonathan Shoff.
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You May Need to Update your Entity’s Operating Agreement
Since S-Corps have various restrictions such as restrictions on ownership and distributions you may need to update the operating agreement of your entity to reflect all of the tax rules for S-Corporations.
If your entity’s operating agreement doesn’t conform to all s-corporation rules, regulations, and restrictions the S-Corp tax status of your entity may be revoked, which would potentially cause the owners of this entity to face a large amount of penalties. Not fun for anyone.
S-Corporation owners must be paid a reasonable compensation through a payroll service
When you elect S-Corporation status, you must ensure that shareholder-employees receive reasonable compensation for the work they perform for the business.
The problem with shareholder compensation is that the owner’s salary is subject to payroll taxes. (Bummer.)
The gap between excess business profit and shareholder compensation is where a lot for the tax savings is derived for the owners of S-Corporations.
Is the solution to set your salary to zero or maybe $10,000 per year? >> That is probably not legally allowed.<<
The IRS requires that S-Corporation owners are paid a reasonable salary for the work they perform for their business that is comparable to what other similar businesses would pay for similar work to be performed.
Obtaining and documenting the lowest salary legally allowed optimizes tax efficiency and keeps you in compliance with the law.
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Need help choosing and documenting salary that will maximize your tax savings?
Click the link below to schedule a call with the founder of Shoff Accounting:
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Real Estate should never be held by S-Corporations
Real estate held in an S-Corporation is subject to certain tax disadvantages. For example, if the property appreciates in value and is sold, the gain could be subject to both corporate-level tax and individual-level tax when distributed to shareholders.
This can result in double taxation compared to holding the real estate in other structures, such as a limited liability company (LLC) or partnership. It’s best to keep real estate in your personal name, an LLC, or a partnership. Note that keeping real estate in an LLC or Partnership can help to assist in providing asset protection in possible future lawsuits.
When Should You Upgrade your Business to an S-Corporation?
The following are general rules for a business that **might** be ready to upgrade to an S-Corporation: Profits are consistently above $150,000 each year. The business has a great bookkeeping system / service already in place.
The business owner has a goal of increasing tax efficiency and is willing to do the leg work it takes to stay compliant with the S-Corp requirements and tax regulations
Note that meeting the requirements of the list above does not guarantee that your business will see a positive ROI from upgrading to an S-Corp the first year, however, if profits are growing a positive ROI should be seen in a short period of time.
Speak with a tax planner for assistance with weighing the costs and benefits of upgrading your entity to an S-Corp
Click the link below to schedule a call with the founder of Shoff Accounting to see if our services are right for you
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Want help with navigating your S-Corporation properly?
Click the link below to schedule a call with the founder of Shoff Accounting:
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