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Recent Tax Court case doesn't mean you shouldn't set up an S corp

There are many factors to take into account when choosing the most favorable business entity for your start-up, such as management style, the source of your financing, what kind of products or services you offer, liability risk, and tax considerations.

For many small companies, setting up an S corporation can be an effective way to avoid the self-employment tax and double taxation on corporate income. The idea, according to the IRS, is that income, losses, tax deductions and credits pass through to the shareholders, who then pay any federal taxes due when they file their individual tax returns.

In a recent, widely-reported case, one S corp’s 2006 tax return was audited, and IRS decided it had underpaid its employment taxes by reporting the president’s salary. Although there was apparently an agreement in place that his annual salary would be $24,000, Forbes reports that the his salary was reported as zero on that tax form.

The IRS said the salary was properly $100,755 and wanted $10,000 in unpaid FICA and FUTA (unemployment) taxes, plus penalties for failing to make timely deposits of those taxes. The president appealed all the way to the U.S. Tax Court. Ultimately the court determined his proper salary was $83,200, recalculated the taxes owed, and fined him $6,000.

That case has raised concerns among many business startups in the process of choosing an advantageous business entity, but those concerns are probably overblown. A properly devised S corp eliminates the self-employment tax an entrepreneur would owe as a sole-proprietor. The primary issue in this case arose because the president failed to comply with the IRS’s requirement that the shareholder-employees of S corporations be paid “reasonable compensation.”

In this regard, S corporations are riskier than C corporations. For C corps, the IRS typically finds unduly high salaries to be disguised corporate dividends. For S corps, the agency may find that corporate distributions are actually salaries, and unpaid payroll taxes are subject to greater penalties than those of unpaid dividends.

The real lesson, however, is not that S corporations don’t offer substantial tax benefits, but simply that no tax strategy should be attempted in an effort to avoid self-employment or payroll taxes altogether.

The proper creation of a business entity is only the first step -- ongoing compliance with that entity’s legal requirements is necessary to ensure its benefits are reliable and secure. There are many resources for calculating corporate taxes, but a knowledgeable tax attorney can flag potential issues and keep them from becoming costly mistakes.

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