The S Corp Check List

S Corps are a popular choice for operating a small business.  But they have some peculiarities that are commonly overlooked and could dramatically impact your tax liability.  If you have an S Corp, or want one, read on.

S Corp Checklist

  1. S Corps are frequently formed for the purpose of avoiding SE tax on a portion of the profits.  Has the owner received reasonable compensation for services provided (through payroll) so that the IRS would not be likely to classify all profit as payroll?  The IRS in particular looks to see a number for Compensation of Officers in Box 7 on the 1120S, and frequently audits if there isn’t one.  Some S Corps take a shortcut by sending the owner a 1099 and still reporting the payment in Box 7, and then further complicating the matter by claiming more business deductions on the personal return.  While this may seem to mitigate the problem by having a number in Box 7 and at least paying some self-employment tax, there is still a great chance of being caught and the downside consequences are enormous.  Both the IRS and state will assess penalties which could be in the tens of thousands of dollars.  So:  pay reasonable compensation.  Of course, if the S Corp doesn’t have the profits to afford reasonable compensation, then no payroll is required.
  2. Dividend distributions (or more appropriately, net profit flowing through to the owner on the K-1) are appropriate if not all of the income is derived from personal services, but rather from goodwill, machinery, intellectual property, or other capital.  Is this appropriate?  Has the owner paid out part of the profit in dividend distributions so as to take advantage of this legal tax avoidance?  The payroll should not be set so high that the Corporation has a loss on the K-1, since this would create a higher tax bill than a sole proprietorship.  Payroll taxes would have to be paid on the entire salary, instead of on the lower net profit figure.
  3. Special procedures apply to for deducting Healthcare Premiums of S Corp shareholders.  The premiums must be paid or reimbursed by the Corporation and included in W-2 wages for the shareholder (although not subject to Social Security, Medicare, or SDI).  This procedure is peculiar and requires special handling on the payroll, the W-2, and the K-1.  Has this been done?
  4. Reimbursements for home office, auto, travel, meals, cell phone, interest on loans to the company, etc., must be made before year end if the Corporation is to receive a deduction.  Otherwise these are deductible on the owner’s Schedule A, as miscellaneous itemized deductions reduced by 2% of AGI.  Has reimbursement been made?  It is best to reimburse monthly (contemporaneously).  Business miles should be reimbursed on the last day of each month at the mileage rate in effect ($0.575/mile in 2015, $0.54/mile in 2016) or actual expenses, whichever method produces the higher result.  We recommend using the standard home office allowance (maximum $1500) to avoid creating depreciation recapture. The home office must be used for vital tasks that cannot be performed at the main office, if there is one.
  5. Per diem reimbursement may be used for meals while travelling out of town on business.  If the Company paid for some of the meals, the Company may reimburse the shareholder for any days in which the actual expenses were less than the per diem.  In a way, this creates tax-free income for the shareholder who eats cheaply.  Should this be calculated and reimbursed regularly?
  6. The S Corp produces flow-through income for the owners.  Has this effect been predicted and the owners prepared?  Have estimated tax payments been made?  Have minority shareholders been informed?  We recommend that S Corps write into their bylaws that they will regularly distribute 50% of the net K-1 earnings to each shareholder, so that the shareholders can make regular estimated tax payments.
  7. S Corps only permit certain eligible shareholders – have there been any changes in shareholders that might terminate S Corp Status?
  8. Section 179 limitations apply at both the Corporate and Shareholder levels.  The limit was permanently raised to $500,000 in 2015 for businesses that purchase $2 million or less in qualifying equipment.  Before filing the S Corp return, the shareholders should confirm that they can use all the Section 179 deduction elected by the S Corp.  If one or more shareholders have used their Section 179 limit in another business, claiming the bonus depreciation instead will give them a deduction (but not as large) that they can use.
  9. Transfers of property into an S Corp by its owners is generally a tax-free transaction with the corporation receiving a carry-over basis from the owner.  There are exceptions when liabilities are transferred and when there is “boot” (cash or property other than stock) received in exchange by the shareholder.  However, property transfers by S Corps to their owners may have tax implications.  This is one reason we do not recommend that an S Corp own appreciating property.  Furthermore, the S Corporation cannot claim a depreciation deduction on property that is still owned by the owners.  Have property transfers been made that need to be recorded?  Should property be purchased, sold or transferred before year end to generate deductions?
  10.  If the S corp began this year, its predecessor may have a short tax year and the return may be due early.  Has this been considered?  If the S corp terminated during the year, it may have a short tax year and an early filing requirement.  The late-filing penalty for S Corps is $195/month per K-1, up to a maximum of 12 months.  Accordingly, we do not recommend S Corp elections to flakey taxpayers who regularly file late.
  11. One class of shareholders is permitted for S corps.  This means all dividend distributions must be made pro-rata to every shareholder in proportion to their ownership interest.  Has this been done or does it need to be equalized before year end?
  12. Built-in gains (BIG) tax recognition period exists for former C Corps.  This tax applies to the sale of an asset that appreciated in the hands of the C Corp and is sold within 5 years of making the S Corp election.  Does BIG exist and should proper records be maintained to estimate the tax bite for selling BIG assets?
  13. C-Corp NOL and Capital loss carryforwards are suspended during periods of S Corp existence.  Are there substantial carryforward that could reduce taxable income if the S Corp status were revoked?  Should the S corp status be revoked to activate any of these carryforwards?  Remember that changing back and forth may only be done after 5 years.
  14. Distributions in excess of basis may create capital gain income for the shareholder.  This frequently happens when the S Corp has liabilities other than to the shareholders.  Basis could be restored if the shareholders loan money to the S Corp.  Does basis need to be restored before year-end to avoid an inadvertent tax on excess distributions?
  15. Hobby loss rules apply to S Corps.  Is this a consideration here?  Should the owner document the profit motive by updating the business plan or making changes to the operation to more effectively pursue profitability?
  16. Is the S Corp adequately insured and carrying workers compensation if there are employees?  Should the owner who has multiple risks purchase an umbrella policy?  This is a good time to review all insurance coverage.
  17. There may be licensing issues related to S Corps in the trades and professions.  Is the S Corp in compliance with licensing?
  18. There is an $800 minimum Franchise Tax in California, to be credited against a 1.5% tax on profits, requiring prepayment.  Has this estimate been paid?  Considering the 1.5% tax or any other consideration, should consideration be given to changing the entity status?
  19. For S corp owners who own multiple businesses and offer employee benefits like pension plans and health insurance coverage – have the benefits been co-ordinated with the other businesses to avoid running into a “controlled group” issue with the IRS?
  20. Have the books and records been maintained in a professional manner with a clear segregation of the operations of the business from the personal assets of the owners, like the use of a separate, corporate checking account from which only business bills are paid?  (This protects the treatment as a corporation and preservers personal liability protection).