Is an S Corp the Business Entity for you?
Is an S Corporation the business entity for you? Read about the popular S Corporation structure and the noncompliance issues the IRS is currently addressing. Also review the Chart below to examine the varying characteristics between the Sole Proprietorship, Partnership, S Corporation and C Corporation structures.
S Corporations Under Attack
In 1958, the Subchapter S Corporation was added to the Internal Revenue Code as an entity to promote small business growth by combining the liability protection of a corporation with the pass-through attributes of a partnership. S corporations now represent approximately 70% of corporate returns filed. This popularity is due to is its ability to deduct losses at the shareholder level. In addition, the S corporation earnings and related distributions as not subject to employment/self-employment taxes.
On January 21, 2010, the U.S. Government Accountability Office released a report concerning S corporations titled “Actions Needed to Address Noncompliance with S Corporation Tax Rules. These noncompliance issues included the following:
- 68% of S corporation returns filed for tax years 2003 and 2004 misreported at least one item of income.
- A substantial number of S corporations deducted personal expenses and were unable to substantiate deducted expenses.
- The report also states that approximately 13% of S corporations paid inadequate wage compensation, resulting in just over $23.6 billion in net underpaid wages.
- A common error was the deduction of losses in excess of basis. Calculating and tracking basis was one of the biggest challenges in complying with S corporation rules.
Inadequate Wage Compensation
If shareholders provide services, take distributions, or receive loans, they must take out a reasonable salary that is subject to employment tax. The IRS has become concerned with the ability of the taxpayer to avoid employment taxes by paying distributions when they should be paying themselves a salary. Another potential problem in an S Corporation is paying too low a salary. Failure to take out a reasonable salary can result in the IRS reallocating distributions or profits as compensation.
The Treasury Inspector General for Tax Administration (TIGTA) prepared a report on inadequate officer compensation in S corporations. This report showed the following:
- If S corporations had filed as sole proprietors in 2000, an additional $5.7 billion would have been paid in employment taxes.
- The report showed over 36,000 S corporations with operating profits in excess of $100,000 paying no salaries to the shareholders.
When determining if an officer’s compensation is adequate, an S corporation should:
- Consider the officer’s performed services for the corporation;
- Consider the prevailing rate of compensation for comparable positions in comparable businesses; and
- If the rate is less than other non-owner individuals who have a role in managing the business.
S corporations can offer employees the same fringe benefits as other business entities.However, fringe benefits deductible for an S corporation must be included in the wages of 2% shareholders who are employees.These items include medical expenses, accident and health care insurance premiums and medical savings account.Before the S corporation can deduct fringe benefits paid by shareholder/employees, the shareholder needs to be reimbursed for any of these fringe benefits they paid.The amount of fringe benefits paid on behalf of the shareholder will be included on the W-2 in box 1, and the health insurance payment will also be shown in box 14.
Shareholder Stock Basis
A shareholder’s stock basis is determined at the end of each of a corporation’s tax years. Stock basis increases when a shareholder buys new shares, contributes capital and when income is passed-through by the corporation.It decreases when a shareholder disposes of shares, when losses or deductions are passed through and when nontaxable distributions are received.
Basis recorded must be correctly maintained because basis limits the amount of corporate loss a shareholder can deduct.It also determines gain or loss when stock is disposed of and determines the amount of tax-free distributions a shareholder can receive from an S corporation.Losses and deductions passed through to a shareholder can be deducted only to the extent of basis at the end of the corporation’s tax year.Loss and deduction items that cannot be deducted because of this limitation carry over indefinitely and are deducted in a later year to the extent that the shareholder has basis at the end of that year.
Failure to File Penalty
An S corporation is required to file their corporate return by March 15th or September 15th, if an extension is filed. A failure to file penalty of $195 is assessed per-shareholder, per-month on S corporations who file their corporate tax return after these dates.The penalty is an entity-level penalty and is based on the number of shareholders for a maximum of 12 months, unless the corporation can show reasonable cause. Given the new base rate, the maximum penalty amount per shareholder is $2,340.
Which Business Entity Is Best for You?
Which business structure might be best for your professional needs? See the chart below for highlights of some of the defining characteristics between the different business entities. Call our offices if you have further questions or want a better understanding of how certain business structures operate.
|Sole Proprietorship||Partnership||S Corporation||C Corporation|
|Organization||Simple, Organizational Cost Minimal||Easy to Form - Flexible||Easy to form, however has additional requirements than a Partnership for free treatment.||Easy to form, however has additional requirements than a Partnership for free treatment.|
|Personal Liability||Unlimited - unless a disregarded LLC||Unlimited - unless a disregarded LLC||Limited Liability||Corporations have an indefinite life.|
|Continuity of Existence||None||Technical termination if within a 12-month period 50% or more of the total interest in capital and profit is sold or exchanged.||S Corporations have an indefinite life.||C Corporations have an indefinite life.|
|Ownership||Allows for only one owner (unless owned jointly by a married couple)||No limits on ownership||Limitations on the number and the types of owners||No limits on ownership|
|Distribution||Distributions do not apply for Sole Proprietorships.||Generally distributions of appreciated property to partners without recognition of taxable gain.||Distributed appreciated property treated as sale-gain recognition. Tax free to extent of basis of shareholder.||Distributed appreciated property treated as sale-gain recognition. Distributions to extent of earnings and profits are taxable as dividends. Dividentd may be subject to the the new 3.8% Medicare tax.|
|Self-Employment Taxes||Subject to the full FICA limit. Medicare no ceiling.||General partners subject to SE Tax. Limited partners not subject to SE Tax.||No SE Tax on distributive share of income.||FICA and FUTA only on salaries, not earnings.|
|Income Taxation||All income taxed at the individual level.||No tax at Partnership level. Income is passed through to each partner, thus taxation at the partner level. Passive income,not derived in ordinary course of business, could be subject to the new 3.8% Medicare Tax.||No double tax. Income passed through to shareholders, thus taxation at shareholder level. Passive income, not derived in ordinary course of business, could be subject to the new 3.8% Medicare Tax.||Potential double taxation in liquidation and distribution.|
|Fringe Benefits||Self-employed health insurance deduction. Spousal employment can allow for totally deductible health insurance and medical reimbursement.||Accident and health insurance treated as guaranteed payment to Partners. Self-employed health insurance deduction applies. Employ spouse for deductibility at partnership level.||For 2% S Corporation shareholders and related parties, health insurance is added to W-2 and deducted on personal return. Other benefits are treated as compensation.||C Corporations can offer a number of tax-advantaged fringe benefits to shareholder/employees, as well as to non-owner employees.|