June 2, 2020
The Consequences of Improper S-Corp Management
We've written a lot about the benefits of a well-managed and advised S-Corporation but today we'd like to address some of the consequences of mismanaging that same entity. Often the penalties of this mismanagement are much more costly than any benefit you can receive from being an S-Corp.
What do we mean when we say improper S-Corp management? Put simply, it's electing for the IRS to treat you as an S-Corporation and then not ACTING as an s-corporation. That can take many forms but we'll address some of the most common:
Payroll
This is the #1 audit trigger for S-corporations: no contest. As an officer of an S-Corporation, you are required by the IRS to be paying yourself a reasonable wage from the business. This figure fluctuates depending on the industry you are working in but goes from 25-50% of your net income (income after expenses). Talk to your Formations representative today to see if you are keeping within the normal range of wages to avoid this common audit trigger.
Co-mingling personal and business funds
Another potential issue for S-Corp is the mixture of the shareholder(s) personal and business transactions. The IRS dictates that the S-Corp and Shareholders be treated as separate entities so when you use the business accounts for personal purchases it creates a "bridge" between the two entities that the IRS, state, and local governments can walk across to scrutinize further your personal finances. In other words, should your business be audited and the government sees a lot of personal purchases on the accounts they can walk across that bridge to your personal tax returns and scrutinize them as well for improper deductions.
The commonality between these two most common mistakes is not treating your business like a BUSINESS.
Now that we've pointed out some of the pitfalls of mismanaging your S-corp let's see what sharp, pointy spikes are waiting at the bottom of those pitfalls:
Federal or State Audit
While an audit for an S-Corporation is statistically uncommon it is still a risk, and even riskier if you aren't managing your company correctly. As we've mentioned above being audited in your business can lead to audits in your personal taxes as well, which at the very least can be expensive to defend. Also if you're found to have materially misrepresented your taxable income it can lead to additional tax, penalties, and interest that will be compounded by how long in the past the audit is looking, not to mention the ability for auditors to go even deeper into the past based on the original audit period results.
And the IRS is not the only agency to worry about: you can be audited by state and local agencies as well and often these audits have far more weight and much stricter penalties attached to them. Depending on your state the business tax revenue may be the largest chunk of state revenue and those states do NOT mess around about it.
Dissolution and Amendment
In extreme cases, usually as the result of a particularly nasty audit, your S-Corp can be administratively dissolved by the IRS all the way back to its creation. This means, depending on the age of the S-election, that multiple years of not just your business returns but your PERSONAL as well will need to be amended and any tax difference paid, with penalties and interest.
Say you're an S-Corp for 5 years, haven't taken payroll, and co-mingled your business and personal the whole time. You get audited and the IRS declares your S-Corp dissolved and your election revoked. This invalidates 5 years of 1120S filings, and by consequence also creates a new reporting of your income on your 1040 for that same period. The tax difference can be staggering, and when penalties and interest for non-payment are levied as well you can be in arrears multiple tens of thousands of dollars, depending on your average income during that period.
With the explosion of popularity of the S-Corp tax structure in the last several years, the IRS is taking notice of this entity more and more and treating it with increased scrutiny. Now more than ever it's important to make sure you are managing your business correctly, and Formations can help with that. Think of us as your business's financial and tax insurer.