Small businesses are my favorite client, especially family businesses. Diane & David Bowling of Commercial Construction and Renovation, LLC , Jackson, TN, said about my tax preparation: Thank you! You truly are a “Super Lawyer.”
New clients often come to me for advice on forming a new business. Some are interested in S corporations since S corporation earnings are not subject to the self-employment tax. There is a lot more to know before you choose an S corporation. I was once in house counsel and CFO of a $15 million dollar + S corporation. S Corporations have pluses and minuses. The rules are complex. They are audit magnets. One of my clients suffered criminal investigation because the IRS did not understand the rules.
The S corporation is an unusual hybrid business entity. It is a corporation under state law. However, for federal tax purposes, the IRS treats it much like a partnership. However, there are key differences between an S corporation and a partnership that confuse the shareholders.
For a corporation to become an S corporation it must file an S corporation election (Form 2353) within two months and 15 days (75 days total) of the date of formation for the election to take effect in the first tax year. The corporation itself is not taxed. Instead, the character and amount of income and deductions pass through to the shareholders. S corporation income is reported on a Form 1120 S and shareholder shares are reported on a K-1 form.
Shareholders’ wages. The IRS has ruled that S corporations must pay shareholders wages for their services, subject to social security and Medicare withholding, which must be matched by the corporation, so it is equivalent to self-employment tax. S corporations not paying wages to owners may draw IRS audits.
One class of stock. Furthermore, S corporations have other complicated rules and can lose their status easily. For example, an S corporation can have only one class of stock. No preferred stock.
Limits on shareholder loss deductions. Generally S corporation’s shareholders cannot deduct losses exceeding the sum of their stock cost plus what they loaned to the corporation. Loans to the corporation from third parties don’t count. Shareholders don’t like to worry about these nuances.
IRS Audits. Shareholders tend to misunderstand some rules and to abuse others. So, the IRS loves to audit S corporations. The IRS is challenging these cases and often wins in the Courts. Furthermore, the IRS does not understand the rules so I have seen them suggest criminal investigation where it was not warranted.
My advice. I have formed and managed several successful S corporations. However, they are not suitable for many taxpayers. I advise getting expert legal advice before making a deci.