3 Things Business Owners Need to Get Right
Electing S Corporation status is only the beginning. Once the election is made, business owners have rules to follow each year to maintain their S Corp status and avoid unnecessary taxes, penalties, and other problems.
Here are three common pitfalls that can cause problems after the election has been made.
Pitfall #1: Underpaying Reasonable Compensation to Shareholder-Employees
What this pitfall is
One of the primary tax benefits of an S Corporation is the ability to pay shareholder-employees a salary and take remaining profits as distributions. The problem comes when business owners try to minimize payroll taxes by taking most or all of their income as distributions while paying themselves little or no salary.
The IRS requires shareholder-employees who provide substantial services to the business to receive reasonable compensation. If wages are unreasonably low compared to the work performed, the IRS may reclassify distributions as wages, resulting in back employment taxes, penalties, and interest.
How to avoid it
- Work with Barklee Financial Group to determine and document reasonable compensation based on industry standards, job duties, experience, and time devoted to the business.
- Shareholder-employees should receive a regular W-2 salary that reflects the work they perform, and compensation should be reviewed each year as the business and the owner’s role change.
- Using a payroll company can also help ensure the appropriate state and federal payroll filings are handled correctly. Barklee can help set up payroll services for your business.
Pitfall #2: Ignoring Ongoing S Corp Compliance and State-Level Differences
What this pitfall is
Once you become an S Corporation, you can’t simply assume your S Corp status will remain in place forever. Certain ownership changes, financing arrangements, or stock structures can unintentionally violate S Corp eligibility rules and terminate the election.
Business owners also need to maintain appropriate corporate records, and state requirements can add another layer of complexity. Not every state treats S Corporations the same way.
How to avoid it
- Before making changes to ownership, financing arrangements, or shareholder agreements, talk with your tax and legal advisors to make sure those changes will not affect your S Corp status.
- Keep corporate records current, document major business decisions, and if you begin doing business in another state, find out how that state treats S Corporations before you expand.
Pitfall #3: Assuming Federal Income Tax Is Based on Distributions Instead of Net Income
What this pitfall is
This is a common source of confusion for S Corp owners. You may take $50,000 out of your business during the year, but that does not necessarily mean you will only pay federal income tax on $50,000. The amount distributed to the owner can be drastically different from the net income of the company.
How to avoid it
- S Corporation owners generally receive income from the business in two ways: W-2 wages paid through payroll and the remaining net income of the company.
- Because an S Corporation is a pass-through entity, the company’s net income passes through to the shareholder’s personal tax return through Schedule K-1. That means the amount of money you take out of the company and the amount of income you owe taxes on are not necessarily the same.
Understanding that difference is important when estimating taxes and planning cash flow throughout the year.
Avoiding S Corp Problems Starts With Good Planning
An S Corporation can offer valuable tax benefits, but those benefits come with rules and responsibilities. Paying yourself a reasonable salary, maintaining your corporate records, understanding state requirements, and knowing how your business income will be taxed are all part of operating an S Corp correctly.
At Barklee Financial Group, we work with business owners to manage these requirements throughout the year—not just when it’s time to file a tax return. If you have questions about your S Corporation or aren’t sure whether you’re handling payroll, distributions, or other requirements correctly, contact the Barklee Financial Group team.
