January 2009

Operating Your S Corporation

Tax traps

Many clients operate their business as an S corporation. Corporations exist in part to shield the personal assets of shareholders from liability for the debts or actions of a corporation.

Chances are you are not only a shareholder (owner) of your corporation, but also its president and chief executive officer (CEO). That means you wear two hats: You are both an owner and an employee. As you will see, this distinction is important.

A corporation may reward its shareholders for their monetary investment in the business by paying a periodic dividend. Dividends are a distribution of business profits. S corporation dividends are generally not taxable.

Employees, on the other hand, are rewarded for their services by the payment of a salary or hourly wage. Wages, unlike S corporation dividends, are always taxable. If you are an S corporation shareholder/employee you cannot avoid income taxes by disguising taxable payments for services rendered as non-taxable dividends.

The Internal Revenue Service advises:

“When a shareholder-employee of an S corporation provides services to the S corporation, reasonable compensation generally needs to be paid. This compensation is subject to employment taxes. Tax practitioners and subchapter S shareholders need to be aware that Revenue Ruling 74-44 states that the Internal Revenue Service (IRS) will re-characterize small business corporation dividends paid to shareholders as salary when such dividends are paid to the shareholders in lieu of reasonable compensation for services.”

Such a re-characterization of dividends by the IRS will result in federal and state penalties and interest on the failure to withhold and pay payroll taxes in a timely manner.

Chances are you are the most important employee (maybe the only employee) in your corporation. Therefore, before you receive any shareholder dividends, you should pay yourself a reasonable salary.

As mentioned above, your corporation can protect your personal assets from judgment creditors in the event of a lawsuit. This protection, however, is not absolute. To receive the legal protection your corporation may afford there are certain rules you have to observe.

Courts sometimes allow judgment creditors to “pierce the corporate veil” and hold shareholders liable for the debts of the corporation. If that happens, assets you own personally can be used to satisfy your corporation’s judgment creditors: your house, your personal savings account – everything!

Here are some factors that courts consider when entertaining a motion to pierce the corporate veil:

1. Intermingling of assets (cash, equipment, etc.) of the corporation and shareholder
2. Treatment by a shareholder of corporate assets as his/her own
3. Siphoning of corporate funds by the dominant shareholder(s), leaving the corporation with little or no cash
4. Absence or inaccuracy of corporate records and books of account

To avoid running afoul of the IRS and the courts, know and play by the rules.

Below are ten suggestions:

1. Open a business checking account in the name of the corporation. Use your corporation’s federal identification number – not your Social Security number.
2. If needed, obtain a credit card for the corporation. Do not use your personal checking or credit card account for business purposes.
3. Deposit all customer receipts into the corporation’s checking account.
4. Pay all business expenses out of the corporation’s checking account.
5. Make sure your corporation’s name – not your name – is printed on your company’s sales invoices.
6. As an employee, you are entitled to a reasonable wage. This wage should be paid by corporate check, subject to payroll taxes, on a regular basis: weekly, by-weekly, or monthly.
7. As a shareholder, you may receive a quarterly or annual dividend provided (1) you have first paid yourself a reasonable wage, and (2) there are accumulated business profits out of which to pay dividends.
8. Amounts paid to you (wages and dividends) should be deposited into your personal checking account. Use your personal checking account, not the corporation’s checking account, to pay your personal bills.
9. Never write a check payable to “Cash.” There are good legal, tax, and practical reasons why you should not do this.
10. Code each business disbursement using the Chart of Accounts we have provided you.

Do these simple things and you will greatly reduce your chances of unpleasant surprises at the hands of the taxing authorities and courts. We are here to help and guide you.

VB&T Certified Public Accountants, PLLC