S-Election? Three reasons to not do it
Filing as an S-Corporation is a popular way for small business owners to operate. There are a number of benefits to filing this way, but there are some definite drawbacks. When we meet a new client, the entity selection is one of the things we will review.
One advantage to filing as an S-Corporation is the ability to manage the social security and medicare tax burden. Generally speaking, all income of a partnership or sole proprietorship allocated to a taxpayer will be subject to social security tax up to the annual limit as well as medicare taxes. Setting a salary as an S-Corporation employee allows a small business owner to manage this cost since only the W2 wages are subject to social security and medicare tax. However, this brings us to our first and second reason to not do it.
Compliance and Administrative Burden
If you are sole proprietor with no employees and decide to make an S-election, you will now need to be prepared for some additional work and cost.
- You will need to file Form 1120-S separate from your personal tax return. While it is possible you were able to get away with filing your sole proprietorship on your own, we would not recommend preparing this form without help from a firm that specializes in small business accounting and tax.
- You will need to pay reasonable compensation to yourself. This will require making payroll tax deposits, filing quarterly returns and ensuring that the compensation is actually reasonable.
State-Level Tax Issues
While S-Corps are pass through entities for federal tax purposes, state tax treatment can vary. Some states impose franchise taxes, minimum taxes or other fees that can offset federal tax savings.
For example, the State of California charges a minimum franchise tax fee of $800! Not only do you have to pay a fee, but you will have to register with the Secretary of State to notify them you are doing business in the State. Guess what – there is a fee to do this.
Profit Distributions and Loss Limitations
One of the joys of being a small business owner is that you can take the cash out of the company and use the funds to cover your personal expenses – or can you? The rules regarding taking profits from an S-Corporation are complex. In some cases, business owners have cash in the company, but they do not have the ability to take the money out without incurring a tax burden. Why is that?
One of the primary reasons for this condition is that there is not enough previously taxed income sitting in the cash account. How can that be?
We typically encounter this scenario with debt financed asset purchases. Assets are purchased in one year, are completely expensed in that year and then are paid off with a loan over a number of years. The income was driven lower, but there is cash in the bank. All good to take that money out ? Better check with your accountant to see how much of that can be taken out before you write the check.
One other issue that can trip up an owner of an S-Corporation is disproportionate distributions. Distributions must be taken proportional to your ownership percentage. If this rule is violated, it can cause an inadvertent termination of the S-Election. This situation can only occur when there are multiple owners. One owner might take cash out and the other takes nothing. That is a disproportionate distribution because the distributions are uneven.
THIS IS ALL JUST TOO MUCH!
Not sure what to do with your entity? As you can see, you need to be on your toes to make sure that your S-Corporation is being managed correctly. We work with dozens of S-Corporation owners to ensure they are in the right entity and are making all the right moves. If you have interest in discussing this further, feel free to schedule a call with us to explore your situation.