Are you considering changing your LLC or C-corporation from the entity’s default tax treatment to an S-corporation election? Now is a great time to get educated about the pitfalls to avoid when making that transition. Our TFG tax professionals would like to point out the most common mistakes entrepreneurs make when switching to S-corp tax treatment and how to avoid them.
- Missing the filing deadline: Avoid a delay in getting S-corp tax advantages by being aware of the deadlines for submitting a Form 2553. If you miss the deadline, the S corporation election will be effective the following tax year.
- Existing LLCs and C corporations with a calendar tax year must file Form 2553 by March 16, 2026.
- Existing LLCs and C corporations that follow a different fiscal year have until two months and 15 days after the start of their fiscal year to file Form 2553.
- New LLCs or C corporations have two months and 15 days from their date of formation or incorporation to file for S-corp tax treatment.
- Not checking eligibility: Do not spend time and money filing for the election if your entity doesn’t meet IRS criteria:
- Domestic corporations only,
- Have only allowable individuals as shareholders, no partnerships, corporations or nonresident alien shareholders are permitted,
- Have no more than 100 shareholders,
- Have only one class of stock,
- Have a tax year ending on Dec. 31 or meet the qualifications (or obtain approvals) for using a different fiscal year.
- Ineligible corporations include certain financial institutions, insurance companies, and current or former domestic international sales corporations.
- Having no payroll: Business owners who are hands on in the business’s operations must set up payroll to pay themselves and other owner-employees actively working in the business. This can create a learning curve for business owners who are accustomed to taking owner’s draws from the company’s bank account. Our sister company Your Payroll Solutions can assist with the various payroll tax accounts you’ll need to establish, as well as the withholdings reports and remittance schedules you’ll need to follow, and be sure you are compliant with employment laws at the federal, state and local levels.
- Ignoring the reasonable compensation rule: The IRS requires S-corp shareholder-employees to pay themselves a “reasonable salary” for the work they perform. If owners take an unreasonably low salary and compensate themselves with disproportionately high distributions to lessen their Social Security and Medicare tax obligations, they will put themselves at great risk. Failure to pay reasonable compensation may lead to IRS penalties and reclassification of distributions as wages, with back taxes owed. Reasonable compensation is based on industry standards, job duties, experience, and comparable wages for similar work, allocating 40% to 60% of net income to salary is considered safe.
- Not following the 2% rule: Whereas employees in C-corps may receive fringe benefits tax-free, this is not the case for S-corp shareholders who own more than 2% of their company. Benefits such as health insurance premiums must be reported as taxable wages on those shareholders’ W-2 forms. This 2% rule is designed to prevent small groups of owners from avoiding payroll taxes through untaxed benefits.
- Awareness of required State S-corp election filing for residents and/or non-residents, and of jurisdictions that don’t provide pass-through tax treatment to S-corps such as New York City, District of Columbia, New Hampshire, Tennessee, and Texas.
Reach out to us: Now is the time to be sure you have the information needed to avoid common mistakes and oversights. Our expertise and guidance can help navigate past the hazardous bumps in the road and lead to a smooth journey as you start and grow your business. Questions can be directed to CPA@fuoco.com.
