Many businesses elect to operate as an S corporation to take advantage of federal tax benefits. The primary reasons for electing S status are limited liability of a corporation and the ability to pass corporate income, losses, deductions and credits through to shareholders. In other words, an S corporation generally avoids double taxation of corporate income — once by the business and again when distributed to the shareholder. Instead, S corp shareholders pass through tax items to their personal returns and pay tax at their individual income tax rates.

Not every business is eligible to be an S corporation

To elect to be an S corp or to convert to S status, your business must:

  • Be a domestic corporation and have only one class of stock,
  • Have no more than 100 shareholders, and
  • Have only “allowable” shareholders, including individuals, certain trusts and estates. Shareholders can’t include partnerships, corporations and nonresident alien shareholders.

In addition, certain businesses are ineligible, such as insurance companies.

Keep compensation reasonable

Another important consideration when electing S status is shareholder compensation. The IRS is on the lookout for S corps that pay shareholder-employees an unreasonably low salary to avoid paying Social Security and Medicare taxes and then make distributions that aren’t subject to payroll taxes.

Compensation paid to a shareholder should be reasonable for a comparable position. If a shareholder’s compensation doesn’t reflect the fair market value of the services he or she provides, the IRS may reclassify a portion of distributions as unpaid wages. The company will then owe payroll taxes, interest and penalties on the reclassified wages.

Consider all the angles

S corp status isn’t the best option for every business. To ensure that you’ve considered all the pros and cons, contact us. The tax rules can be tricky — especially when converting an existing business — and there are potential traps for the unwary.

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