When I ask a new client what kind of company they have, invariably they say that they have an LLC. When I ask if it's a Sole Proprietorship, Partnership, S-Corp, or C-Corp I get a look like I've grown a second head. "I don't know." They reply. While the S-Corp is very popular, it is not really understood by a large number of business owners. In this article we will examine the issues behind the subchapter S-Corporations and the advantages to making that election.

Not too long ago a new entity known as the Limited Liability Company (LLC) began and each year there are many new LLCs being formed. However, as popular as the LLC has become, the S-Corp status is still considered the favorite or most beneficial of all forms of incorporation. Unlike the C-Corp, in which the owner's get taxed both on the revenue of the company and on the distributions they take as well, with the S-Corp, the owners or shareholders are only taxed on their share of the distributions. That alone is a reason to form an S-Corp as it combines the advantages of getting taxed as a Partnership would with the protection of the C-Corp status. There are reasonable restrictions on the election of an S-Corp which cannot be formed as a pass-through entity nor can it be a foreign entity.

Abuses Cause IRS Tax Law Changes

As with any entity there are changes every year within the IRS to deal with abuses to the system. It became common for owners of S-Corps to under pay themselves as CEO's to avoid paying higher taxes on personal returns. Starting in this tax year, the IRS will be taking a closer look at those S-Corps whose CEO's are not earning what they consider a "Reasonable Compensation".

The IRS considers a "Reasonable Compensation" as being what the business owner would be paid by another company of similar size to do what he or she does for their business. If the amounts are not even close that business owner can expect an auditor to come calling.

Equally disturbing (to the IRS anyway) is the issue of excessive compensation. Exceeding the IRS's definition of excessive can also prompt the audit as well. Some business owners have even gone so far as to include supporting their mistress in a lavish lifestyle as an expense to the company. After all, the spouse would miss a $75,000 withdrawal from a personal account, but not necessarily from the business account.

Advantages to the S-Corp Status

1. Shareholder Benefits - Any officer with a greater than 2% share may have their medical insurance, Health Savings Account or Health Insurance premiums deducted from the company revenue before taxes. These benefits however, for the purpose of payroll must be treated as part of their salary, if indeed these officers are drawing a salary. Another limitation on this is that the deduction is limited only to the extent that the S-Corp actually makes income.

2. Office in Personal Residence - There is a two-fold test as to whether an area in a home may be deducted as an office in home. First, the area must be used regularly for business purposes. Regularly means of course, on a regular basis and whether that be 8 hours or more daily or once a week the concept is that it be on a regular basis. Second, the area must be used exclusively for business purposes. Nightmare stories are told about a business owner using the Home office deduction and it being completely disallowed because of a simple thing like his allowing the children to use the internet, watch TV, etc in the same room, or having a guest sleep over in the office during a weekend stay. If there is ANY activity occurring in that room other than strictly business related work, the entire deduction is in jeopardy.

One word of caution on this deduction for the S-Corp is that the deduction goes on the Form 2106, not as an expense on the 1120S. Remember that this income flows through to your personal return and you are personally taking this deduction for the home office.

For those 'creative' tax preparers who suggest that you rent part of your home to the S-Corp and deduct the entirety of the rent, utilities, etc. Remember then, that you will have to claim that rent as income on a Schedule E, and if the rent per square foot is not at Fair Market Value, the IRS may deny that deduction or at the very least, radically reduce the amounts of deductions you take.

S Corporation Red Flags

Any S-Corp with more than one shareholder may have an arrangement of convenience with the 'partners' who are more silent than they are 'partners' But these red flags will catch the attention of even the laziest IRS Auditor and should be avoided as it could lead to the voiding of the S-Corp status.

a. Disproportionate Distributions - all shareholders must be treated as equals. In other words, you cannot have one of a group of shareholders taking distributions and the others not taking distributions. Neither can you have one shareholder taking a disproportionately different distribution than the others. You must however; take into account the original basis the shareholder has in the S-Corp.

b. Distributions in Excess of Basis - if one shareholder has a 20% share in the corporation, all distributions must be based on that share in the corporation. I.e. you cannot have a 20% shareholder receiving a distribution of 35%.

c. Limits on the pass through of losses. - Occasionally, a company will experience a loss and in an S-Corp. these losses are passed through to the shareholders personal returns. But if the investment was a passive one and the passive shareholder is not actively involved in participating in the running of the business, that deduction for the loss may be disallowed.

For all the regulations and expense of operating an S-Corp it is and will remain to be one of the more popular forms of business.