Should My Business be an S-Corporation?

Last year a client asked the following question:

I recall that earlier in 2010 an accountant at your firm suggested that I could reduce my payroll taxes if I change my business status to a S corp.I dont recall if that was officially done, although I recall providing some information for paperwork.

Our answer to that question:

    • It is true that an S-Corp could help reduce the taxes owed at the end of the year
        By eliminating Self-Employment (SE) taxes on part of the income (S-Corporation pass-through income is not subject to SE Taxes while Schedule C Income is SE Income under the IRS code), and

By withholding income and employment taxes from company paychecks and depositing those taxes on a more-frequent basis rather than making estimated tax payments each quarter or paying at the end of the year when you file your personal tax return.

    • The other side of that, however, is that the accounting has to be much more precise and consistent with a corporate entity than it does for a sole proprietor.
        When income is reported on a cash-basis Schedule C (part of your personal tax return), only the income actually received and the bills actually paid are reported. There is no need to track accounts receivable (income that has been billed but not collected) or accounts payable (amounts due for expense that have been incurred but not yet paid).

When a business entity changes to an S-Corporation, however, it does have to report – or at least compile – balance sheet amounts (Cash in Bank, Accounts Receivable, Fixed Assets, Accounts Payable, Loans payable, etc.) and if the return is ever audited, the company has to be able to support those balances with auditable, contemporaneous, detailed accounting records.

In addition, the S-corporation is required to compensate its shareholders and owners (as well as any other employees) for the services they perform for the company, and that compensation must be in the form of W-2 (i.e. employment) income, from which federal and state income taxes and Social Security and Medicare taxes have been withheld, matched and remitted to the appropriate tax agencies on prescribed forms and schedules.

In other words, the business must have a valid business purpose and it must operate like a business, part of which includes maintaining appropriate business, accounting and tax records. Note: The IRS does not consider reduction of self-employment taxes to be a valid business purpose.

While written IRS codes and regulations dont indicate that there is a higher accuracy and support standard applied to Entity returns (S- and C-Corporations, LLCs and Partnerships) than there is to Schedule C returns, in practice that is clearly the case.

  • As long as the company and the company owner are essentially the same taxable entity (sole proprietorship or single-member LLC), companies often get by with less formal accounting standards and procedures.
  • Consequently, Schedule C businesses have a history of being audited by the IRS about 5.0 to 5.5% of the time (approximately 1 out of 20 returns) while only 2.25 to 2.75% (approximately 1 out of 40) of other business entity types (C-Corps, S-Corps and partnerships about 1 out of 40) are audited on a regular basis.
  • This difference is undoubtedly due to the typically lower level of accounting practice in Schedule C returns. However, entity audits, audit tolerance and resulting penalties on entity audits also tend to much more rigorous and severe than they are for unincorporated business entities.

The net conclusion we draw from all this is that, unless a client is willing (and able) to handle the additional cost and effort involved in maintaining a solid business management and accounting process, we dont believe they should operate in the form of an incorporated business.

If you have questions about your business entity, contact us! We can help.

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