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The S-Corporation Trap

Have you ever received the advice that you should elect to have your business taxed as a S-Corporation to save on taxes? A S-Corp election is the new favorite tax planning strategy for a lot of accountants and many people will make a blanket recommendation without evaluating the actual business. And that is a mistake! We see a lot of clients who have walked into the S-Corp trap without realizing it only to be stuck in a tax election that doesn't make sense for them. Let's walk through how this works:

A S-Corporation is a hybrid between a flow-through entity and a C-Corporation. It is technically a flow-through entity, but has characteristics that differentiate it from other flow-throughs such as a partnership and a sole-proprietorship. Partnership income and sole proprietorship income is all subject to FICA taxes (15.3% for self-employed individuals). It is also subject to federal income tax. As a taxpayer if you are making a high amount of income in one of these tax structures it can cost you a significant amount in FICA taxes (also known as self-employment taxes to a lot of business owners). A S-Corporation can limit FICA taxes. The income from a S-Corporation is not subject to FICA taxes. That sounds like a no brainer, but there's a catch. As an owner working in a S-Corporation the owner is required to be put on payroll for reasonable compensation. The payroll is then subject to 15.3% in FICA taxes.

Paying a low payroll should solve this right? Not necessarily! An owner/employee in a S-Corporation has to pay reasonable compensation through payroll, or what it would cost to pay someone else to do the work they are doing in the business. This issue is one that the IRS is increasing their focus on during audits. If reasonable compensation is low in comparison to the income for the business this could make the S-Corporation election make sense. But if it is close and/or equal to the amount of the income it probably will not make sense. Here's a breakdown of some of the issues that you may see when electing S-Corporation status:

  1. The cost of payroll and compliance in a S-Corporation is going to increase the expenses being spent on software and other programs.

  2. The S-Corporation tax return is far more complex than a Sole Proprietorship and is can be more complex than a partnership return. This is going to increase your tax filing costs.

  3. S-Corporations can be far less flexible than partnerships and sole proprietorships. They are limited to one class of stock and distributions have to be equal to the stock share percentage. Partnerships are far more flexible in this area. S-Corporations are subject to basis limitations for distributions, sole proprietorships do not have these issues.

  4. If distributions are not be taken due to constant reinvestment in the company a C-Corporation with a flat tax rate, more employee benefits for shareholder/employees, and potential long-term benefits like the Section 1202 exclusion which allows the sale of C-Corporation stock tax free up to a certain amount for qualifying C-Corporations may make more sense.

  5. It reduces your Qualified Business Income Deduction when compared to a partnership and sole proprietorship.

  6. Terminating a S-Corporation election puts limitations on when it can be elected again. So if you weren't quite at the point where a S-Corporation makes sense, but may be in a few years you might be stuck either in the S-Corporation now or in a less advantageous structure in the future.

How can you avoid these issues? Do not make a S-Corporation election based on a blanket assumption that it is going to be the best option for reducing your taxes. An actual evaluation of your tax treatment options and how they work with your short term and long term goals should be done before deciding how you would like your small business to be taxed.

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