When starting a business, it’s common to wonder how you should structure your organization. One common structure is the S-Corporation, or “S-Corp.”
S corporations pass corporate income, losses, deductions, and credits to their shareholders for tax purposes.
This means that business shareholders report income and losses from the business on their tax returns. Then, income is taxed at ordinary tax rates. S corporation shareholders must be individuals, specific trusts and estates, or certain tax-exempt organizations.
Is My Business Eligible for S Corp Status?
Suppose your business is a domestic corporation with no more than 100 shareholders. In that case, registering as an S corporation could be an excellent financial move. When registered as an S corp, your business can “share” your taxation with your shareholders by allowing your income, losses, deductions, and credits to flow through the shareholders first. Then, your tax return reports income and loss. The result is avoiding double taxation on corporate income (yay for tax savings!)
As with all tax rules and regulations, it’s common for businesses to make mistakes. Here are three common mistakes we see in our practice.
#1 Lack of Reasonable Compensation
The potential tax savings available to an S corp are very exciting. Still, the IRS expects your corporation to meet eligibility requirements.
Among these is the requirement for the S corp owner to receive a “reasonable salary.” As with everything related to the IRS, there’s some subjectivity here. What exactly constitutes a reasonable salary?
To figure this out, consider how much you’d make in your current business if you worked for an employer. You should also research salaries paid to other workers in your industry. There’s no hard and fast rule, which can be frustrating. But this is where the help of a tax expert could come in handy!
#2 Lack of Sufficient Net Income
As a pass-through entity, the S corp is used to avoid double taxation, which occurs when taxes are paid twice on the same income.
An S corporation doesn’t pay taxes on net income (sales minus expenses). Because of this, some unscrupulous business owners may try to game the system, reporting little or no net income to avoid paying taxes.
To avoid IRS suspicion, make sure you’re honest with your numbers.
But what if your business operated at a loss for the year? Operating at a loss can have unexpected tax consequences when the shareholders do not have sufficient stock and/or debt basis. When a loss is realized without sufficient stock and/or debt basis the shareholders may have additional income to report subject to capital gains tax.
#3 Commingling of Funds
Mixing personal and business expenses can cause huge accounting problems.
For one, failing to keep your book organized into personal and business categories can muddy the waters when it comes to knowing your actual numbers. The result is that you may not know which purchases are tax deductible and which ones aren’t.
Additionally, you could be setting yourself up for an audit by blurring the lines between personal and business funds.
While not explicitly required, the IRS strongly recommends business owners create a separate business bank account to avoid this common pitfall.
Hire a Taxpert to Keep Your Sanity
If trying to keep track of these rules and regulations makes you dizzy, you could benefit from the help of a tax expert! Let the Tax Savvy Jessica team take the reins. We promise – you’ll sleep easier knowing your taxes are being done right!