S-Corporation: The Good, the Bad, the Scary (Part 1)

Some time ago I started writing a series of columns discussing potential tax problems posed by various business structures.  “Avoiding the Hobby Tax Trap” presented the danger, consequences, and how to avoid having a business reclassified as a hobby by the IRS.  “Business Owners: Lower your Red (Audit) Flags” warned sole proprietors of three audit triggers commonly found on their tax returns.  One most recent column, “Home Office Deduction Danger” discussed the (often overlooked) requirements for claiming the Home Office deduction. For those interested, these articles are available at both http://www.journal-news.net and http://hbsbusiness.com.

Today I will begin a discussion on S-Corporations.  The basics and their potential benefits for owners.  But first a word of warning: Business structures are highly complex.  Any single article (or series of articles) will barely scratch the surface.  The tax benefits provided by a particular business structure at one end of the business life-cycle can quickly become a major tax-headache at the other.  Before choosing a particular structure, research your options and obtain professional assistance from both an attorney and tax professional. Then, make this important decision yourself.  It is, after all, your business.

Overview: S-Corporations are “elected” business structures for tax purposes.  One does not file with the Secretary of State to become an S-Corporation.  Instead, an eligible domestic (US based) corporation of other eligible entity (for example an LLC) files Form 2553 to elect to be treated as a S-Corporation for tax purposes. 

An S-corporation can have up to 100 eligible “shareholders.”  Generally, only US citizens or resident aliens, estates, and certain trusts and estates can be shareholders.  S-Corporations are also only allowed to have one class of stock.

Potential Benefits:  There are several benefits S-Corporations can provide to owners.  A few are listed below.

  1. Psychological Separation:  A major benefit of forming an S-Corporation is a shift that commonly occurs in the way the owners view their business.  Changing from an informally operated sole proprietorship or partnership to a more formal structure such an S-corporation often engenders a new seriousness in the way the owner views their business.  Along with an increased importance of procedures and record keeping comes the realization that the owner(s) now wear two separate and distinct hats.  First, they are formally investors – shareholders charged with making their business profitable.  Second, the owner is also an employee responsible for seeing that day-to-day work gets completes and customers remain happy.  This newly-found, objectivity and perspective is a prerequisite of business growth.
  2. Flow-Through of Losses: When a business is in its start-up phase or traveling through a rough patch such as the current recession, owners often put in money to keep the business afloat.  Because S-Corporations are a “flow-through” entity, these losses may be deductible on the owner’s personal return.  This would not happen with a C-corporation, where losses remain locked up on the corporate level unless carried back or offset be future profits. S-Corporation shareholder losses, however, are limited to the shareholders “basis.”  Tracking and properly applying basis is a challenge we will discuss in later column.
  3. Potential to Reduce Certain Taxes:  The fact that S-Corporation owners wear two hats, those of both an investor and employee, requires the owner to two forms of compensation.  First, an investor is entitled to a return on their risk and investment.  An employee, on the other hand, is required to receive a salary/wages for any work done for the business.  This means that, as long as owners are paid a REASONABLE salary/wage for services provided to the S corporation, distributions in excess of wages are not subject to the 13.3% (for 2011 and 2012) Social Security and Medicare tax. Please note: This issue is highly complex and a hotbed for IRS scrutiny.  A wage paid to an owner/shareholder must be reasonable for service provided.  Also distributions made to a shareholder that exceed “basis” are potentially taxable as BOTH ordinary income and capital gains.  This issue will be discussed in our next column.
  4. Avoid double Taxation of C Corporations: Because S-Corporation profits are (generally) taxed once on the shareholder’s level, the “double” taxation of earnings at the C-corporate entity level and shareholder level as dividends is avoided.

Today’s column has discussed the potential benefits of S corporations.  Later columns will visit the many tax-challenges that accompany these benefits.  As always, this article or any article does not constitute tax advice.  If you would like to speak with a tax professional, please feel free to contact our office to make an appointment.

 

Brett Hersh's avatar
  • Author: Brett Hersh
  • Bio: Brett Hersh, EA, MBA, is the owner of HBS TAX & Small Business Experts. He is an Enrolled Agent (EA) with the IRS and licensed by the US Treasury Department to prepare all tax returns and represent taxpayers before the IRS for audits, collections and appeals. He is also Dave Ramsey’s ELP for Tax and Accounting, a continuing education instructor for tax professionals through Lorman Education, and a local speaker/presenter on the topics of tax and business growth. He can be reached at (304) 267-2594.