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Top Ten S Corporation Mistakes to Avoid
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Top Ten S Corporation Mistakes to Avoid

The S corporation still remains the most popular business vehicle. The S corporation has been given support in the past several years by legislation from the Congress that has removed some of the impediments to its use and by the liberal treatment the Service now regularly doles out with respect to once fatal mistakes. Nonetheless, there are still plenty of ways the owner can make mistakes for which there is no relief.

  1. Failure to make proportionate contributions in formation. Many deals wed the "money" interest with the expertise interest, but §351 only provides nonrecognition to persons contributing property in exchange for stock. Shareholders who contribute services cannot escape taxation when unrestricted stock is received. While unrelated persons can deviate somewhat from a strictly proportionate contribution based on their own arm's-length valuation of property contributed, large deviations enable the Service to construe the transfer as being at least in part for future services with adverse consequences to the shareholder.
  2. Failure to use nonvoting stock. Sometimes the business owner would like to make a gift of stock to children or others but is fearful of giving control over to the children. Retaining control of the stock denies not only the estate- and gift-tax benefits but also the income-tax benefits that would accrue if the child is treated as a shareholder. While preferred stock cannot be issued in an S corporation, nonvoting stock can, and since there are little or no "control" features to control with such stock, the owner can shift taxable economic interests without the fears associated with voting stock. Nonvoting stock is not a separate class of stock from the class of voting stock for S corporation purposes as long as the economic rights are the same.
  3. Failure to use debt. Lending money to an S corporation serves an important role in providing additional basis for the recovery of losses. Use of such basis, however, reduces the basis in the obligation below face that can result in a gain when the corporation pays off the loan. While open account debt can likewise provide basis, a written obligation is often overlooked despite the fact that the repayment of a written obligation will result in capital gain to the shareholder while repayment of an open account is taxed as ordinary income.
  4. Failure to structure debt correctly. Despite never-ending cases that deny a shareholder guarantee as the tax equivalent of a shareholder loan to the corporation, shareholders continue to fail to structure the trip to the bank so that they -- and not the corporation -- are the borrowers. Doing this right will create a shareholder loan and, when the proceeds are in turn loaned to the company, current basis; doing it wrong creates only a guarantee that doesn't create basis unless and until the corporation defaults and the shareholder makes an actual economic outlay by repaying the loan.
  5. Failure to make proportionate distributions. In order for the corporation to have a single class of stock, the economic interests must have the same rights to distributions. This means that whatever amount is apportioned to a share is apportioned to each share. The regulations permitted certain timing differences as between distributions to one set of shareholders and another if the early distributions are treated as below-market loans with the corporation, but otherwise don't make distributions to one shareholder and not to another.
  6. Failure to take into account limitations at the entity level. Tax items such as the §179 expense are applied at both the corporate and shareholder levels. This has two related implications. First, as the corporation cannot elect to expense above the annual limitation ($105,000 in 2005), the shareholder owning less than 100 percent of the stock cannot maximize his or her own limitation from that corporation. Conversely, the shareholder may have a portion of §179 expense allocated from several entities, each less than the annual limitation but in the aggregate in excess of the limitation, an excess that cannot be used in any taxable year. This is not a mere loss of a deduction, but a cause of additional future tax. The shareholder's basis in the stock will be reduced dollar-for-dollar of allocated §179 expense even if the shareholder cannot use some of it. Short of relief by the basis step-up at death, the shareholder has created phantom future gain by a basis reduction without corresponding tax benefit.
  7. Failure to take adequate salary. The leading cases in this area involved accountants who unsuccessfully attempted to avoid Social Security taxes by treating all payments received as distributions not subject to employment tax, rather than as payment for services that are. In addition, in a family corporation, the Service can reallocate the K-1 income to a shareholder as wages if it determines that the shareholder is inadequately compensated for services performed. Multiple Service Centers are flagging S corporation returns with less than a certain level of compensation reflected as officers' compensation.
  8. Failure to obtain earned income by relying on distributions. Most pension and other retirement benefits are premised on the existence of earnings. In a partnership or LLC, general partners and the LLC-equivalent members can have earned income without distribution at all on the pass-through income that is earned income. In contrast, even items at the S corporation level that are earned income are not for pension-limitation purposes if they are taxed to the shareholder as part of the shareholder's pass-through. A shareholder needs W-2 income from the corporation to support a retirement-plan benefit or contribution.
  9. Failure to provide for benefits disproportionate to stock ownership. Special allocations are permitted in an LLC or partnership, but they are strictly forbidden in an S corporation. However, there are ways of achieving this goal, such as through disproportionate salary structures that may be available. Other benefits, such as life insurance coverage, can be disproportionate without creating a second class of stock.
  10. Failure to provide for post-sale consequences to a selling shareholder. The operation of the per-share/per-day allocation and apportionment scheme can allocate unexpected income or loss to a departed shareholder arising after that shareholder sells stock. Such allocation then changes the shareholder's date-of-sale basis for computing gain or loss on the sale. The shareholder can find more or less capital gain or loss than was anticipated at the time of the sale. One overlooked method of locking in consequences at closing is by electing to close the books of the corporation, thereby forcing any post-sale tax allocations and apportionments only to the shareholders of record during the balance of the taxable year.

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