3 Reasons Why I’m Recommending S Corps Less Often
Back when I started my career in accounting (circa 2005), CPAs were in love with S Corporations. Tax classification as an S Corporation was highly recommended to almost all small business owners—mostly due to the potential payroll tax savings. At that time, I was working at a small firm of about 30 or so CPAs—and electing S Corp status was very helpful to most clients at our firm. However, as I think back on that experience now, the majority of those who elected S Corp status hired a competent individual to perform their bookkeeping and generally paid a firm like ours to prepare the books, the S Corporation return, and the individual returns for the owners.
However, times have changed substantially since then. Many developments have transformed the bookkeeping and tax preparation process, and many owners now have the confidence to prepare their own books and file their own tax returns. Sometimes this confidence is misguided and results in unfiled returns, late-filed returns, problematic books, tax notices, massive tax balances, and substantial penalties and interest. Other times, taxpayers are able to self-prepare a competent set of books and file a mostly correct return on their own. Unfortunately, it is usually the former and not the latter. Notwithstanding, small business owners are still largely being steered down the path of forming S Corporations for the tax savings either via online research, tax professionals, or recommendations from other small business owners. I am finding myself advising clients more often to rethink that suggestion, and in my consultations on the topic I am recommending the S Corp less often to clients who have started a new business. Here are 3 of the reasons why.
Many Business Owners Underestimate the Required Compliance
Sole proprietorships are easy. When I say “sole proprietorships”, I’m referring to both unincorporated entities owned by a single person as well as single-member LLCs. The owner files a single tax return which encompasses all of his or her taxable income, including the income from the business he or she owns. Sometimes, a proper set of books can even be kept using a spreadsheet rather than purchasing accounting software.
S Corporations, on the other hand, are not easy. They require a timely properly made election (more on this later), a full set of books complete with bank reconciliations, increased due diligence, and have a completely different due date from the individual return. S Corporations are not for the faint of heart. 😊 Those who do not want to hire a bookkeeper (or learn to keep proper books), run regular payroll, file W-2’s and other quarterly and annual payroll tax returns, file an additional income reporting return each year, and track shareholder basis (or hire a knowledgeable person to do this for them) should not elect S Corporation status. I’m starting to see—more often than not—that new clients I am taking on have already run afoul of at least one of these requirements, and many of them have run afoul of several of them. And the consequences can be severe.
The IRS Is Rejecting Late S Elections
Once upon a time, in a land far away, a taxpayer would make a late S election and the IRS would accept it (despite the Service’s wide latitude to reject them). Oh, I harken back to those wonderful days. 😊 However, I’m finding now that the IRS seems to be rejecting late S Corporation elections by default. Even worse, this is happening with late S elections submitted with an S Corporation return. Worse still, I’ve seen the IRS notify a taxpayer that it is automatically converting the S Corporation return into a C Corporation return and reclassifying the distributions as salary when the IRS did not consider the shareholder’s salary reasonable in the year the late election was submitted.
S Corporations have been ripe with abuse for many years. Shareholders have not paid out the reasonable salaries dictated by operations and the time and services they contributed to the company, they have not filed the necessary payroll tax returns timely, they have not maintained proper books and records, and have deducted losses in excess of their basis. The IRS appears to be closing these holes based on some recent developments with information reporting and updated forms for both the S Corporation and individual tax returns. It is time for small business owners who are not willing to do (or pay for) the requisite compliance to think twice about forming S Corporations—especially when a late election is involved.
The TCJA Makes Sole Proprietorships More Attractive
The Tax Cuts & Jobs Act that was enacted in 2018 makes sole proprietorships more attractive than they once were. This makes sense, as one of the major goals of this legislation was to simplify the Tax Code. And I would largely say that it has done just that by drastically reducing the number of taxpayers that itemize deductions and also bringing taxpayers that file sole proprietorship returns more on par with taxpayers that file as S Corporations. Post TCJA, smaller S Corporations don’t tend to offer the amount of tax savings that they once did in comparison to sole proprietorships. This is especially true when you consider the costs of additional tax and payroll compliance, maintenance of books and records, and basis tracking that S Corporations require. As of now, the provisions in the TCJA that have put sole proprietorships more on par with S Corporations last until 2025, so until then, my default recommendation for most business with a single owner will be filing as a sole proprietorship, unless the situation truly warrants making an S election or C Corp classification and the client is confident that he or she can meet the obligations of doing so.
If you have started a business recently and are wondering whether an S Corporation is right for you, please don’t rely solely on information available on the internet! You can contact me (a licensed attorney and CPA) for a consultation using the form below and we can review the factors I’ve outlined above (and several others) with an eye toward your specific circumstances. Thanks for reading!