Although S corporations do not pay corporate income tax, there are still many financial pitfalls you should avoid around tax time. If you can escape making these five S corp taxes mistakes, it could save you money and protect your tax status.
What is an S Corporation?
For tax purposes, a corporation can elect to be treated as an S corporation, which means the company’s net taxable income is taxed at personal tax rates rather than corporate ones.
According to the IRS, “S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.”
Common Pitfalls to Avoid in S Corp Taxes
1) Electing to become an S Corp too late
The government offers a narrow time frame for businesses to elect to become an S corporation. A Form 2553 must be filed by:
- The 16th day of the 3rd month of a corporation’s tax year
If you have launched a new business during the course of the year, a 75 day time limit begins from your first day of operations. But, if you miss this deadline, you can still apply as long as you enlist the help of a certified public accountant.
If you are interested in S corporation tax benefits, don’t wait until tax season to apply for a change your business status, because it may not be possible.
2) Not Separating Personal Assets from Company ones
As you begin to prepare your S corp taxes, another common mistake to avoid is comingling your personal and corporate transactions. Business owners should not pay for personal obligations out of corporate funds. It is also strongly suggested that personal and corporate debt be kept separate.
3) Shareholder-Employee Compensation
Many S corporations have shareholder-employees who own part of a company but also work there.
Even though the part-owner of a small business might not take a regular paycheck, IRS rules direct S corporations to pay a reasonable compensation to their shareholder-employees. Since tax issues may arise for shareholder-employees who do not receive a yearly Form W-2, it’s best to pay them in the same manner as all other staff members.
4) Shareholder Loans
For tax purposes, it’s also very important to document all shareholder loans. Whether the loans are to or from your company, they need to be accounted for prior to filing taxes.
Document shareholder loans with a promissory note, which includes repayment terms and agreed-upon interest rates.
5) Poor Credit Financing Reporting
Another common S corp taxes mistake is poor credit financing reporting, which causes shareholders to pay more in personal income taxes.
S corps may take out loans and lines of credit in the name of their business, but this does not result in the most advantageous tax return savings. Instead, it is a smart strategy to borrow money directly from the bank and then provide a loan to your company.
Following these steps can help you avoid costly penalties and overpaying on income tax. If you have any additional questions, consult a professional tax preparer.