An S corporation (“S Corp”) offers significant tax advantages, but it comes with strict rules that must be followed to maintain its status. Violating these rules can lead to losing the eligibility to file as an S Corp, also known as “Blowing S Corp,” and increased taxes. Let’s dive into how S Corp can be blown up, the fallout that follows, and what you can do.
The Promise of S Corp Tax Savings
The primary tax advantage of an S Corp lies in its ability to minimize self-employment (“SE”) taxes. Unlike sole proprietorships or partnerships, where all profits are subject to self-employment tax, S Corp owners only pay these taxes on their salaries. The remaining profits, paid out as distributions, are not subject to self-employment tax. This structure can save thousands of dollars annually—if done correctly.
S Corps are limited to 100 U.S. individual shareholders. Further, the owner of an S Corp must pay themself a reasonable salary and subject it to wage withholding.
Both of these requirements introduce opportunities for non-compliance. You may meet the requirements at the time you elect S Corp treatment and later find that you no longer qualify.
So, now what? We will dive in to each of these potential points of failure and reveal ways you can protect yourself.
(un) Reasonable Compensation – The Fuse That Can Ignite an IRS Audit
An S Corp’s tax advantage relies on a balance—wages versus distributions. Too much of one results in an explosive mixture. The IRS demands that shareholder-employees receive a reasonable salary before pocketing SE tax-free distributions. But some owners play with fire, setting their salary far too low in an attempt to maximize savings.
Enter Watson vs. U.S., a cautionary tale of what happens when the IRS catches wind of an exploding tax loophole. David Watson paid himself $24,000 while siphoning $204,000 in distributions. The IRS didn’t just raise an eyebrow—it detonated his strategy, reclassifying much of his distributions as taxable wages. The court backed this decision, suggesting a $90,000 salary would have been more reasonable based on expert testimony.
The 50% Rule
You may have seen reference to the “50% rule” for reasonable salary. It suggests that business owners should pay themselves at least 50% of their earnings to avoid IRS scrutiny. However, the IRS does not define reasonable compensation as a percentage of earnings.
Instead, the IRS requires S Corp owners who actively work in the business to pay themselves a reasonable salary before taking distributions. This salary must be paid as W-2 wages and is subject to payroll taxes. The amount considered reasonable depends on factors like:
- The market rate for similar roles in the industry.
- The owner’s qualifications and experience.
- The services provided by the owner.
That said, the IRS has their own ways to identify who to audit, and the ratio of wages to distributions in an S Corp may be a factor. While you are safe even if audited so long as you can justify your salary, an audit is disruptive, time consuming and can result in other findings, so best to be avoided when possible.
The Solution
If you’re an S Corp owner, it’s important to document how you determine your salary so you can justify it, if needed. The Bureau of Labor Statistics is a government resource with comprehensive employment and wage data by industry and region at https://www.bls.gov/bls/blswage.htm. You can find several other online resources for comparing compensation data across industries, roles, and locations. Job boards can also be helpful for establishing a reasonable wage.
The bottom line? Underpaying yourself can light the fuse on an IRS audit. If the IRS finds your salary unreasonably low, your distributions could be reclassified, triggering back taxes, penalties, and interest. Don’t let your S Corp tax savings go up in smoke—pay yourself a fair wage and document your reasoning to extinguish risk before it ignites.
Ineligible Shareholder
The S Corp might inadvertently find itself with ineligible shareholders, either due to a lack of oversight or misunderstanding of eligibility rules, or through unanticipated transfers (e.g., estate transfers).
The Risk
If shares are transferred to an individual who is not a U.S. resident, or to an entity like another corporation, partnership, or non-qualified trust, then the business can no longer be considered an S Corp. For example, if an S Corp owner’s estate passes shares to a family member living outside the U.S., or if the shares pass to a ineligible trust, then the S Corp status becomes invalid.
Only qualified trusts meeting specific requirements are eligible to hold S Corp shares. If shares are transferred to an ineligible trust in an estate transfer, the company loses its S election.
Exceeding 100 shareholders also breaks the S Corp status. In some cases, the issue may stem from a misunderstanding of the rules regarding family members. While family members are often counted as a single shareholder for the purpose of the 100-shareholder limit, this does not mean that all family members are automatically eligible shareholders. Missteps in this area can also blow S Corp.
The Solution
Careful monitoring of shareholders and stock transfers is a valid control. Going further, I recommend all S Corps include language in their shareholder stock agreements that allows the business to purchase back shares from the shareholder if a disqualifying event were to transpire. With these provisions, the company can avoid breaking its S Corp eligibility when such normally disqualifying events takes place.
The Fallout – Implications of Blowing Corp
When S Corp is blown, it automatically reverts to being taxed as its default tax classification (e.g., LLC or C Corp). This results in the elimination of the tax benefits allowed for S Corps as well as triggering potential additional taxes related to the liquidation of an S Corp, like the BIG tax. The Built In Gain (“BIG”) tax applies when an S Corp that was previously a C Corp sells appreciated assets within a specified recognition period (currently five years). This tax is designed to prevent corporations from avoiding taxes on gains that accrued during their time as a C Corp.
When an S Corp converts to an LLC, it is treated as if the corporation is liquidated. This can result in the recognition of gains or losses on the distribution of assets to shareholders, which are then reported on their individual tax returns. If the S Corp loses its status and liquidates or converts to an LLC, the sale or deemed sale of assets at fair market value can result in a BIG tax liability.
You will likely also need to split that tax year between a short S Corp year through the date of the event causing ineligibility, and a short year under the default tax classification (e.g., LLC or C Corp) for the remainder of the year, requiring the careful allocation of revenues and expenses between the two.
To prevent these issues, S Corps must maintain diligent oversight of shareholder eligibility and consult with tax professionals when making changes to ownership. Regular reviews and clear communication with shareholders can help ensure compliance and protect the corporation’s status.
Other Considerations
- Five-Year Rule: If the S corporation loses its status, it typically cannot re-elect S corporation status for five years unless it obtains IRS approval. This rule can limit flexibility for businesses that may want to revert to S corporation status in the future.
- Retained Earnings and Accumulated Adjustments Account (AAA): Any retained earnings or AAA balances must be carefully managed during the transition, particularly for C Corps. Distributions made after the conversion may be subject to different tax treatments, potentially leading to double taxation if not handled properly.
- Passive Income Restrictions If an S Corp has accumulated earnings and profits (AE&P) from its time as a C Corp, and more than 25% of its gross receipts come from passive income for three consecutive years, the S corp status can be revoked.
By staying vigilant about shareholder eligibility and reasonable compensation, and using tools like salary benchmarking data, you can secure your corporation’s future and avoid costly repercussions. With diligence and expert advice, you can enjoy the benefits of your S Corp status for years to come—and steer clear of the risks of “blowing up” your tax savings.
Shane Bohlender, MBA, CPA, provides bookkeeping from $199 per month and tax services including S Corps at CPAsity.com
