Are You Ready to Become an S-Corporation (S-Corp)?

S-Corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.

Shareholders (owners) 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, which is seen in C-Corporations.

S-Corporations are responsible for tax on certain built-in gains and passive income at the entity level.

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SOURCE: S corporations | Internal Revenue Service (irs.gov)

• Tax-Favorable Income Categorization

  • Pass-Through Taxation​:  One of the most significant benefits of an S-Corp is the avoidance of double taxation. Corporate income, losses, deductions, and credits pass through to shareholders, who then report these items on their personal tax returns.

  • Self-Employment Tax Savings:  Shareholders of an S-Corp may pay themselves a reasonable salary and receive dividends, which can reduce the amount of self-employment tax paid compared to a sole proprietorship or partnership.

• Non-Taxable Fringe Benefits​ for 2%-or-More Owner-Employees

  • Qualified Retirement Plan Contributions

  • Qualified Dependent Care Assistance Plans​

  • Qualified Educational Assistance Plans

  • Qualified Retirement Planning Services

  • Onsite Athletic Facilities

  • Working Condition Benefits

  • De Minimis Fringe Benefits

  • Qualified Employee Discounts

• Asset Protection

  • Limited Liability:  As an S-Corp, the shareholders' personal assets are generally protected from business debts and liabilities, similar to a C-Corporation and LLC​

• Ease of Ownership Transfer

  • Continuity of Existence:  The S-Corp structure allows for the easy transfer of ownership through the sale of stock, which can be beneficial for succession planning and attracting investors​

• Credibility

  • Professional Image:  Incorporating as an S-Corp can enhance your business's credibility with customers, suppliers, and lenders​

• Closer IRS Scrutiny

  • The IRS scrutinizes S-Corps to ensure that shareholder-employees are not underpaid to reduce employment taxes. Low or zero salaries paired with high distributions can trigger audits

  • The IRS requires that shareholder-employees be paid a reasonable salary, which is subject to employment taxes. Determining what constitutes a reasonable salary can sometimes be challenging and scrutinized by the IRS.​

• Formalities & Costs

  • Increased Administration: S-Corps are required to adhere to strict corporate formalities, such as holding regular meetings, maintaining minutes, and filing annual reports. This can be more burdensome than the requirements for sole proprietorships or partnerships.

  • Formation and Ongoing Costs:  Establishing and maintaining an S-Corp involves costs such as state filing fees, legal fees, payroll, and accounting fees

    • Not all states recognize S-Corps at the state-level​

    • JS Grigsby, CPA, PLLC requires all S-Corp clients to have a professional bookkeeper because of IRS scrutiny of S-Corps​

    • You must pay yourself and officers/owners by W-2 if you work in the business/provide services.  Not properly establishing payroll when your S-Corp becomes effective may cost more in penalties for payroll back tax withholdings; ultimately negating any potential tax savings from the S-Corp election.

• Tax Considerations

  • ​Loss Limitations: Shareholders can only deduct losses up to the amount of their investment in the business. This could be a disadvantage if the business incurs significant losses.

  • Capital Gains:  Shareholder distributions in excess of their basis results in capital gains. Without proper monitoring throughout the year, shareholders may withdraw more than their basis resulting in a capital gains tax.

• Limited Flexibility

  • Stock Classes: An S-Corp can only issue one class of stock, which might limit the ability to raise capital compared to C-Corporations that can issue multiple classes of stock with different rights and preferences.​ Foreign ownership is prohibited.​

• Taxable Fringe Benefits

  • Most fringe benefits provided by the corporation are taxable as compensation to employee-shareholders who own more than 2% of the corporation​

• Be a domestic corporation

• Have only allowable shareholders

  • May be individuals, certain trusts, and estates​

  • May NOT be partnerships, corporations, or non-resident alient shareholders

• Have no more than 100 shareholders​

• Have only one class of stock

• Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations)

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SOURCE: S corporations | Internal Revenue Service (irs.gov)

Reasonable compensation is the salary that the IRS deems appropriate for the work performed by the shareholder-employee. This salary must be comparable to what similar businesses would pay for similar services in the same industry and geographic area.

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Factors considered include the employee's role and responsibilities, the time and effort devoted to the business, the company’s size and complexity, and compensation for comparable roles in similar companies.

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If the IRS determines that the compensation is not reasonable, it can reclassify distributions as wages, leading to significant penalties and back taxes.

• Documentation:  Maintain detailed records justifying* the salary levels based on industry standards and employee contributions

• Regular Reviews:  Periodically review and adjust salaries to reflect changes in the business environment and the shareholder-employee's role

• Consultation:  Work with a CPA* to establish and regularly review compensation policies to ensure compliance and mitigate risks

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Ensuring reasonable compensation is critical for S-Corps to remain compliant and avoid costly IRS penalties. 

*JS Grigsby, CPA, PLLC performs a detailed reasonable compensation analysis. We use a professional software that uses a proprietary blend of IRS criteria, court rulings, geographic data, and an exclusive wage database based on your local county/parish.