Author: Ronica Brown | Estimated Reading Time: 1 minute
S-corporations (also called S-corps) continue to be the most popular tax classifications in America.
They’re so popular because they offer powerful tax savings.
But, they can become a tax nightmare if you don’t know what you’re doing.
You’re probably reading this article because you’re either considering changing your business to an S-corporation or wondering how to reap the tax benefits of an S-corporation.
My team and I often restructure our clients’ tax classification into an S-corp depending on their long-term needs.
Our aim is to help them pay less taxes as business owners.
So, this article is based on our proven track record of using an S-corporation to help our clients pay less taxes.
It covers everything you need to know about S-corporations and S-corporation taxes.
The Table of Contents below contains clickable links. You can use them to easily navigate through this article.
What Is An S-Corporation?
An S-corporation is a special type of corporation that is eligible to be taxed under subchapter S of the Internal Revenue Code. Shareholders of S-corporations benefit from the separation of the business from the shareholders while avoiding corporate taxes.
Profits and losses are passed through to the shareholders who then pay individual income taxes. In essence, an S-corp provides the limited liability protection of a Limited Liability Corporation (LLC) without the burden of corporate taxes.
S-corporations are not legal business entities. They are just tax classifications that tell the IRS how you should be taxed. Eligible legal entities, such as corporations and LLCs, can elect to be taxed as an S-corporation.
They also can’t have more than 100 shareholders. There are also other requirements that you can view on the IRS website.
The only way to become an S-corporation is to file an election with the IRS to be taxed as S-corporation. Again, this is only a tax status that the IRS allows; an S-corporation isn’t a legal entity. The IRS lists the criteria for becoming an S-corporation on its website.
Your LLC can be taxed as S-corporation to help you reduce self-employment taxes.
Also, your corporation can be taxed as an S-corporation to help eliminate double taxation.
Pros Of An S-Corporation
Avoid double taxation.
Business income, losses, deductions, and credits can be passed directly to shareholders without paying corporate taxes.
Shareholders don’t pay self-employment tax on their share of the business’ profits.
Reduce self-employment taxes.
Cons Of An S-Corporation
Reasonable compensation must be paid to employee-shareholders.
Corporate books have to be maintained.
Minutes of at least one annual meeting must be included.
Without proper planning, an S Corporation can lose out on:
Maximizing Qualified Business Income Deduction (“QBI”)
Maximizing Retirement Contribution
A lot of deductions work differently when your business is taxed as an S-corporation. These include:
Home office
Health Insurance
Fringe benefits
Hiring your minor children
...plus more
Do The Pros Outweigh The Cons?
You probably looked at the long list of cons above and decided that an S-corporation isn’t worth it. Don’t strike it off your list just yet. You can reap great tax benefits from an S-corp with proper planning.
That’s often what S-corp owners lack, proper planning. Most people believe that becoming an S-corp is all that’s necessary, that somehow the tax benefits will automatically be applied. That’s not true.
An S-corp can be a nightmare when done wrong. S-corps that are failing from a tax perspective are often failing because they’re:
Missing out on some deductions
Viewed as a red flag for an IRS audit
It doesn’t help to just have your business registered as an S-corp. Your planning has to come together in a way that either eliminates the cons of owning an S-corp or turns them into benefits.
You can benefit from increased tax deductions when an S-corp is done right. I often find about $5,000 or more in missing tax deductions each time I look at an S-corp’s return. That adds up as the years progress. In five years, that’s at least $25,000 in deductions that you didn’t claim.
Here are some questions that you can ask yourself (or your CPA or tax advisor) to determine whether your S-corp status is actually saving you money:
How much is my home office deduction?
Do I have an accountable plan in place?
How can I get paid to do my meeting minutes?
How much is my retirement plan contribution? How can I maximize it?
How much self-employment tax will I be paying?
How much I am saving by being an S-corporation vs LLC or Corporation?
Maximizing the tax benefits of an S-corp can often seem like a lot of work.You may have to revamp your current strategy after you’ve assessed your current S-corp situation.
But, having the right process in place changes that completely.
A properly implemented plan helps you create a process that can be repeated each year. So, the burden becomes far lighter and you save a lot more money.
My team and I specialize in planning around S-corporation taxes. Our planning leads to increased deductions and increased tax and legal compliance. We’ve helped clients over the past few years transition their business focus to items that help them save money.
We designed an S-Corporation service package to help you increase your tax deductions, too! This service will put a process in place for you to lower your taxes and maximize your deductions while remaining compliant with IRS S-Corporation rules. Schedule a tax planning discovery session to learn more.
Understanding how S-corps are taxed can make doing business easy.
Photo by bruce mars onUnsplash
How Are S-Corps Taxed?
The shareholders of an S-corporation are taxed, not the S-corporation. Their taxes only relate to their share of the S-corporation’s profits. It doesn’t matter whether these profits were actually distributed to them. Profits are taxed only once at the shareholder’s tax rate.
But in most cases, S-corp shareholders aren’t taxed on business distributions. These distributions are only taxed if the shareholder’s distributions are more than his or her basis in the S-corporation.
Basis refers to all the net earnings, cash investments, and cash distributions that the business has over its lifetime. It’s similar to home equity; think about it as equity in your business.
It’s really the strength of your cash flow. Do you have enough money to draw against and write off losses? A healthy business has strong equity meaning that you’re making a profit and not taking out too much cash.
Tracking your basis is extremely important to avoid capital gains taxes. My team and I do a lot of work in this area. We have seen prior returns with no basis or incorrect basis that we have to recompute. We aim to save our clients a lot of money on capital gains taxes.
The S-corporation has to pay capital gains taxes on the distribution payments if you take out more cash than the basis in the S-corporation. This results in you being double taxed.
What Are The Tax Benefits Of An S-Corporation?
There are several tax benefits of becoming an S Corporation. I’ll discuss two of the most common benefits.
Avoid Double Taxation
This only applies when you convert from a C-corporation to an S-corporation. You pay taxes at the corporate level and when you distribute money to yourself when you own a C-corporation.
Changing from a C-corporation to an S-corporation allows you to eliminate the corporation level taxes and only pay taxes on your personal return. This means your S-corporation profits will be reported on your personal income tax return.
Here is an example that shows you the tax savings in real dollars.
Example of the tax savings an S-corporation brings.
Reduce Self-Employment Taxes
This benefit applies when you change from an LLC or partnership to an S-corp. When you’re taxed as an LLC or partnership, you have to pay self-employment taxes on the profits up to $148,800 (2021) at a rate of 15.3% (2021).
So, your total self-employment taxes will be a maximum of $22,766 for 2021. You can reduce these self-employment taxes when you become an S-corp.
Let’s say your business has a total profit of $150,000 for 2021. Your self-employment taxes would be at least $22,766 if your business is registered as an LLC.
On the flip side, let’s say you convert the LLC to an S-corporation and pay yourself a reasonable salary of $100,000. You can reduce your self-employment taxes by $7,466.
You’ll take the rest of the money from the business via nontaxable distribution.
| Self-Employment Tax with LLC | $22,766 |
| Self-Employment Tax with S-Corporation* | $15,300 |
| Tax Savings | $7,466 |
The example assumes a $100,000 salary.
How To Maximize The Tax Benefits Of An S-Corporation
Converting your business to an S-corporation and stopping there won’t help you maximize the tax benefits of the change.
The two tax benefits mentioned in the previous section aren’t the only benefits. They only help get you started. Capitalizing on other tax benefits of an S-corporation requires strategic planning.
This is how you can transform all the cons of being an S-corporation into a tax deduction. Here are some tips:
Implement an accountable plan and take cash reimbursement for administrative use of your home office. This can be $5,000 or more in tax-free cash reimbursements.
Formalize your business planning with minutes of at least one annual meeting. The bonus is you can also pay yourself to have these meetings. It’s completely tax-free money. This can be $12,000 or more.
Maximize Qualified Business Income Deduction (“QBI”) - Do a reasonable compensation analysis so that you reduce how much W2 income you pay yourself. When this is done correctly, you can maximize your QBI deduction. The amount is based on total business profits.
Maximize retirement contribution. You have to pay self-employment taxes so that you can contribute to a retirement plan. You can also maximize retirement contributions by adding layers of retirement planning options such as 401(K) and Profit Share Plan.
This strategy provides the benefit of low self-employment taxes and high retirement contributions. You can also get close to a $50,000 contribution when you combine different qualified plans without overpaying in self-employment taxes
A lot of deductions work differently when your business is taxed as an S-corp. So, you want to ensure these deductions are being reported correctly so that you can benefit from them and keep your s-corporation.
Some strategies that can help with this include:
Implementing an accountable plan
Having a family management LLC
Other options based on the deduction you wish to take. Some possible deductions include:
Administrative Home office
Shareholder Health Insurance Premium
Fringe benefits
Hiring your minor children/grandchildren
...plus more
The success of your S-corp depends heavily on reasonable compensation.
Photo by Alexander Mils on Unsplash
Why Is Paying Yourself A Reasonable Compensation Important?
The first tax savings you’ll get under an S-corp relates to paying yourself a low salary that meets the reasonableness test. This makes reasonable salary a hot topic for the IRS.
An S-corporation allows you to completely reduce (and sometimes avoid) self-employment tax or Federal Insurance Contributions Act (FICA) taxes. FICA taxes cover your social security taxes and your medicare taxes. So, FICA taxes essentially replace self-employment taxes paid by an LLC taxed as a sole proprietor (Schedule C filers) or a partnership.
The FICA tax rate is 15.3% and it’s paid in addition to your income tax. Reasonable salary requirements are enforced by the IRS on S-corporations so that the FICA tax can be collected from shareholder employees. It helps the IRS close the self-employment loophole created by forming an S-corporation.
When shareholder employees are paid reasonable compensation, the following taxes are withheld from their W2 compensation:
FICA taxes (social security and medicare taxes)
Federal Unemployment Tax Act (FUTA) taxes
State Unemployment Tax Act (SUTA) taxes
But, these taxes aren’t withheld from distributions paid to shareholders. Some business owners see this as an opportunity to pay themselves a low salary and increase their distributions. Some don’t even pay themselves a salary at all.
That can be a dangerous strategy. The IRS can adjust all your distributions if you don’t pay yourself a reasonable salary or you pay yourself too low of a salary. This results in additional taxes, penalties and interest.
The IRS has guidelines for determining a reasonable salary. For our clients, we look at factors that were considered in tax court cases where the tax court adjusted the taxpayer’s tax return. A lower salary can be achieved, but it has to be supported by real data.
Here is an example from a case put before the US Court of Appeals. It’s the case between Brewer Quality Homes, Inc. and the Commissioner of Internal Revenue. This case revealed ten factors considered by the courts when determining reasonable compensation:
The person’s qualifications
The nature, extent, and scope of the person’s work
The size and complexities of the business
A comparison of salaries paid with gross income and net income
The prevailing general economic conditions
A comparison of salaries with distributions to stockholders
The prevailing rates of compensation for comparable positions in comparable concerns
The salary policy of the taxpayer as to all persons
In the case of small corporations with a limited number of officers, the amount of compensation paid to the particular person in previous years;
Whether the corporation provided the person with a pension or profit-sharing plan
There are many methods that you could use to determine reasonable compensation. One of them is the Many Hats Approach. This method looks at each role you play in the business and assigns a pay rate to each role.
Many Hats Approach Example
Let’s say you’re an attorney working at an independent firm. Your salary from your day job is $250,000 and that would be filed on your W2 form.
You decide to open your own firm. Now, things are different. This is how you typically allocate your time:
50% on attorney work
20% training your team
20% business development
10% admin and finance work
Those are four separate roles. Since most of your skill goes with your attorney role, a salary computation based on all of these roles may determine that your total W2 compensation should be $125,000.
The rest would be taken as a distribution that is not subject to self-employment tax. You can get an official salary analysis by using RCReports to help document your reasonable salary under the different methods.
Distributions can then be planned around these W2 compensation amounts so that there is a clear line between salary and distributions.
A Shareholder’s Salary is Not A Distribution
Some S-corp owners mistakenly treat their shareholder distributions like monthly salaries. S-corp distributions should be disbursed on an annual or quarterly basis. Otherwise, the IRS may classify these distributions as salary.
Your tax advisor can help to put a process in place so that you can consistently pay yourself each month plus be in compliance with these rules.
How To Solve Reasonable Compensation Challenges While Maximizing Your Deduction
We normally recommend that our clients come with a compensation package. Think about it like working for a corporation. Your employer would provide a compensation package that includes all the benefits the business offers, reimbursements, and tax-deferred money.
The compensation package you create for your S-corp should include:
Salary
Health Insurance
Accountable plan reimbursements
Retirement contributions
Tax-Free Fringe Benefits
This can get you to an attractive reasonable compensation number without overpaying on FICA taxes. But, this figure should be evaluated as your business grows to ensure you meet the requirements.
Our experience has shown that there is a lot of noncompliance in the area of reasonable compensation. Sometimes a business owner can go for years without paying themselves a W2 salary, but the person is taking distributions. This is a big red flag that the IRS will notice sooner or later.
We’ve already seen S-Corporation with no payroll completely miss out on the PPP loan and employee retention tax credits. Don’t let the same thing happen to you.
Starting an S-corp is something you can do online.
Photo by Javier Sierra on Unsplash
How To Start An S-Corp
There are several things to consider when starting an S-corp. The first step is to file for an election to be an S-corp. Make sure you’re using the right form!
Also, the deadline for filing differs from one business to the next. It’s best to regularly check the IRS website for updated deadlines.
Here are some general guidelines to consider if you want to start an S-Corp.
New Business
Let’s say you’re creating a new business. You can file an election on the first tax return you file for that business. Normally, the deadline to file an S-Corporation election for a new business is within two months and 15 days of the date of formation.
Existing Business
You could have either an existing LLC or small business corporation. How you form an S-corp for each differs.
How Can I Change My LLC To An S-Corp?
You can change from an LLC to an S-corp provided your business meets the relevant criteria. There are also some key things that you should look out for though when making this change. I discuss these things in this section of the article.
File Form 8832, which covers an entity classification election, if you own an LLC. This form allows you to elect to be a corporation. An S-corporation is a hybrid form of a corporation so your LLC will need to change its entity classification to a corporation.
How Can I Change My C-Corp To An S-Corp?
Ensure your business meets the relevant criteria outlined by the IRS.
Answer the questions listed in the change from c-corp to s-corp section of the article. Feel free to schedule a call with me for more guidance.
File Form 2553.*
*This election must be filed by March 15 each year for you to be taxed as an S-corporation for the current year. For example, if you filed this election and meet all the requirements by March 15, 2022, then you can be taxed as an S-Corporation starting January 1, 2022. This will not change your 2021 tax filing.
What If You File Late?
You know you want to form an S-corp but the deadline has passed. The great news is that the IRS provides accommodations for late elections for any day within the last three years and 75 days. You have to meet the following requirements though to be approved for this:
You will have to state that you intended to operate your business as an S-Corporation from the date you selected on the form to start your S-Corporation status
The business must have met all the requirements of an S-Corporation for those years.
You will also have to provide a reasonable explanation why you failed to file the S-corporation election on time. Again, the IRS’s definition of reasonable is pretty broad so simple statements such as, “You were not aware of the tax requirements” can qualify.
A late election will also need more documentation to support the requirements of late election to go along with Form 2553.
What If You Change Your Mind About Forming An S-Corp?
There is room to make a change to your S-corp election if you change your mind. You can also make the change if you’ve failed to meet the requirements, such as adding another class of stocks or you want to have a foreigner as a shareholder.
The only thing to keep in mind is that you won’t be able to file another election for another five years once you terminate your S-Corporation election. You can terminate your S-Corporation election by:
Converting to an LLC or a Partnership by liquidating the S–Corporation.
Terminating the S-Corporation election and becoming a C-Corporation. You can terminate by simply sending a letter to the IRS as the majority shareholder.
The IRS doesn’t have any specific requirements for this termination letter. So, you can keep it simple. You can also alter your business in a way that doesn’t qualify for the S-Corporation and file a corporation tax return instead.
The Factors We Consider Before Suggesting Restructuring A Business Into An S-Corp
There are some general, non-tax related metrics that we consider before making this suggestion. The industry is one of them. For instance, we never convert a real estate investment company to an S-corporation. There are too many legal issues involved which we won’t address here since we’re not attorneys.
Here are the specific questions we ask for each business category.
Questions To Ask If You Want To Change From LLC to S-Corp
How much in qualified business income deduction does the business owner receive?
What is a reasonable salary for the business owner?
How much in tax-free reimbursement is the business owner eligible for?
What are the business’ total net profits and cash flow?
What are the business’ growth projections?
Questions To Ask If You Want To Change From C-Corp to S-Corp
Are you reinvesting profits or taking cash dividends?
How will tax be paid under the corporate tax rate vs the individual tax rate?
How much in qualified business income deduction does the business owner receive?
What are the business’ total net profits and cash flow?
Common Mistakes Made After Changing To An S-Corp
Business owners and some accountants tend to convert to an S-corporation to minimize self-employment taxes. But, they don’t understand how to maximize their tax deductions and maintain a compliant entity. They often don’t know what’s required to make their S-corp a tax saving entity.
If you’re not taking advantage of a minimum of $5,000 or more in tax-free cash, you’re not getting the full advantage of being an S-Corporation. My team and I typically discover over $10,000 is missed deductions and identify several areas of non-compliance that can cost a company hundreds of dollars in penalties (not to mention being flagged for an audit).
Here are the most common reasons for this failure.
Missing Basic Deductions
Poor planning can lead to your S-Corp missing basic tax deductions. Remember, a lot of tax deductions work differently for S-Corps. So, you’ll end up paying more in taxes than you should if your tax plan isn’t solid.
Poor Bookkeeping And Tax Filing That Leads to an IRS Audit Red Flag
I can’t stress this enough. Accurate record keeping makes a big difference. Red flags are raised by the IRS when they see:
Low reasonable compensation
Incorrect health insurance reporting for owners
It’s best to work with a tax advisor to ensure that you’re not creating problems for your business.
Consistent Monthly Draws Are Being Categorized As Salary
One of the requirements for maintaining S-Corp status is that your shareholders should be paid a reasonable salary. You can’t be making random withdrawals from the business’ profits and classify that as salary!
The salary you receive as a shareholder needs to hit that sweet spot. It can’t be too high because it will be viewed as unreasonable by the IRS. But, you also want it to be low enough so that you can avoid Social Security taxes.
The best way to pinpoint the right salary is to research salaries within your industry. Document your research and pay yourself as if you were hiring someone to fill your role. Also, create a detailed job description to further justify the salary chosen.
Not Maintaining Proper Corporate Minutes
Your S-corp must have at least one annual meeting. Minutes must be taken so that there’s strong documentation to support your tax strategy. Tax-related items that should be discussed in this meeting include:
Shareholders’ salaries
Loans between shareholders and the business
Reimbursements to shareholders
Distributions
Registering As An S-corporation And Then Doing Nothing Else
Tax savings don’t magically appear once you register as an S-corp. Strategic planning must take center stage so that you can transform the cons of owning an S-corporation into benefits.
Final Words
Changing your business to an S-corporation can provide numerous tax benefits. But, it can also lead to an auditing nightmare if you aren’t carefully meeting the S-corp requirements.
Some key points to remember are:
You must pay employee shareholders a reasonable compensation separate from distributions.
Tax-related items should be discussed during shareholder meetings and accurate minutes should be recorded.
There are deadlines that you must meet when forming an S-corporation. Keep yourself abreast of these dates so that you don’t miss them.
S-corporations aren’t legal business entities. They’re just tax classifications.
We’ve helped clients successfully transition their business to an S-corporation. We then help them remain compliant and stress free.
Are you ready for us to help you? Schedule a discovery session where we’ll review and cover:
Reasonable compensation analysis
Additional deductions that are often missed with an S-corporation
Payroll and cash flow process
Accountable plan implementation and reimbursements
Corporate books compliance and minutes
Monthly or quarterly process to use going forward for continued compliance
How our team provides full support and implementation