This tax season again brought an active conversation regarding business structures and taxes. This is a good time to think about the issue; to ask the right questions.
The current hot topic for small businesses seems to be the “S Corporation.” The question I am hearing is: “How do I convert my small business to an “S Corporation”?
I think a better question is: “Should I convert my small business to an S Corporation?”
The answer to that question will give you the answer to: “Will my conversion to an S Corp put more after tax money in my pocket?”
There can certainly be advantages for certain businesses but S Corp election is not a “one size fits all” solution. S Corps come with disadvantages as well and you should think them through before changing. Some of them are:
- Extra Tax Return and Legal Fees ….corporations need professionals: tax professionals, bookkeepers, lawyers
- Extra Paperwork….The S Corporation entails extra structure, formalities, and compliance obligations for the solo entrepreneur with a “payroll of one.” You need to set up a board of directors, file annual reports and other business filings, hold shareholder’s meetings, keep records of your meeting minutes, and generally operate at a higher level of regulatory compliance than your business might need or want to deal with.
- The shareholder must receive reasonable compensation. If you try to cheat the system by paying yourself a lower salary and higher distributions you might claim a tax advantage for the year, but the IRS takes notice of such red flags. If the IRS reclassifies your distributions as wages you’ll be back to paying the higher employment tax and you will be on the IRS’s radar screen for some time to come.
- Transfer of Assets: the assets are owned by the S Corporation. They are not yours. Taking them from the S Corp could easily trigger a taxable action.
- In case of your death, proving the fair market value could be difficult, expensive, and complicated for your heirs.
- Some benefits that shareholder/employees receive can be written off as business expenses. Nevertheless, if such an employee owns 2% or more shares, the benefits like health and life insurance are deemed taxable income and additional bookkeeping/accounting is required.
The tax savings and solidity of the S-Corp also come with a price and you should know what it will be for your business. Don’t rush into a new and more complex business structure on vague promises of lower taxes. It is not that simple! The more information you have, the better!!