Setting up an S corporation can lead to significant tax savings, but common errors can negate those benefits. These mistakes often stem from entrepreneurs trying to cut costs or, surprisingly, from professionals who should know better.
Here are four critical S corporation setup mistakes to avoid:
**1. Overlooking the LLC Advantage:**
An LLC is generally the best starting point for forming an S corporation. LLCs offer the same liability protection as corporations but with less administrative burden. An LLC can then elect to be treated as an S corporation for tax purposes. Starting with an LLC provides flexibility and simplifies initial setup.
**2. Ignoring Foreign Corporation Registration Rules:**
While forming an LLC or corporation in states like Delaware or Nevada may seem appealing, it’s often not beneficial for small businesses. If you operate in a state like New York, you can’t avoid state taxes by incorporating elsewhere. Your state will require you to register your out-of-state entity as a foreign entity and pay income taxes in the states where you earn income. Delaware is advantageous for large businesses involved in complex litigation, while Nevada’s no-income-tax status requires a substantial business presence.
**3. Unnecessarily Electing C Corporation Status:**
In the past, converting an LLC to an S corporation involved first classifying it as a C corporation for tax purposes. This required filing Form 8832 and then Form 2553. Thankfully, the IRS now allows a direct S corporation election using Form 2553. Attempting the old two-step method is unnecessary and can lead to complications. If you make an error in your S corporation election, the IRS is usually understanding. Seek professional help from an accountant or attorney to rectify the issue.
**4. Electing S Corporation Status Too Early:**
Electing S corporation status can save money when your business profits significantly exceed owner salaries. However, making the election too early can be detrimental, especially for single-member LLCs. S corporations require filing corporate tax returns, running payroll (even for a single owner-employee), and potentially paying additional payroll taxes. It’s best to wait until your business is consistently profitable before electing S corporation status. This approach simplifies accounting and reduces tax return costs.