Setting up an S corporation can unlock significant tax savings, but missteps can negate those benefits. Many errors stem from entrepreneurs trying to cut costs, which is understandable but short-sighted. Surprisingly, even legal professionals sometimes make these mistakes. Here are four common S corp setup errors to avoid:
**Mistake #1: Overlooking the LLC Advantage**
An LLC is often the best starting point for an S corporation. Think of an LLC as offering the same liability protection as a corporation, but with less administrative burden. An LLC can elect to be taxed as an S corporation, providing flexibility. Start with an LLC in most cases, rather than forming a corporation directly.
**Mistake #2: Ignoring Foreign Corporation Registration Rules**
Out-of-state incorporations, such as in Delaware or Nevada, may seem appealing, but they rarely benefit small businesses. If your business operates in a state like New York, forming an LLC or corporation in Nevada won’t help you avoid New York taxes. You’ll still need to register as a foreign entity in states where you do business and pay income taxes in those states.
Delaware is popular among large businesses due to its sophisticated chancery courts, but this is irrelevant for small businesses. While Nevada offers a no-income-tax haven, it requires a genuine business presence with an office, employees, and property.
**Mistake #3: Unnecessarily Electing C Corporation Status**
Previously, converting an LLC to an S corporation involved first converting it to a C corporation for tax purposes. This required filing Form 8832 and then Form 2553. Fortunately, the IRS simplified the process, and now you only need to file Form 2553 (S election). Avoid the outdated, multi-step process, as it’s prone to errors and could leave you with an LLC classified as a C corporation but not an S corporation.
If you make a mistake, the IRS is usually understanding. However, seeking professional assistance from an accountant or attorney is advisable.
**Mistake #4: Electing S Corporation Status Too Soon**
Electing S corporation status can save owners substantial money when a business generates profits significantly exceeding owner salaries. However, don’t rush into S corporation status if you started as an LLC, especially if you’re the sole owner.
An S corporation requires filing a corporate tax return, initiating payroll (even for the owner), and potentially paying additional payroll taxes like federal unemployment tax. Wait until your business is profitable before electing S status. This leads to simpler accounting and less costly tax returns.