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Selected Tax Considerations for Small Businesses
by SBC Staff

Given the inevitability of certain approaching tax deadlines, we have seen an increase in questions from visitors to our website about several tax issues that we feel are worthy of discussion here. We'll review each of them briefly now. If you have any questions or want to explore a particular issue in more detail, please contact us with your specifics and we'll be happy to help.


If you transact business through a corporation you can choose to make an election to be taxed as an S Corporation. If you are not familiar with this election, this may sound like we're getting into complicated territory here, but relax. It's not that bad.

An S Corporation doesn't pay tax. Its earnings are passed through to the shareholders who pay tax as if they had earned the income directly. The earnings of a corporation that has made this election prepares a separate form for each shareholder of the company that lists the items of income or deduction that the shareholder must report on his or her individual income tax return. The corporation's S Corporation income tax return, Form 1120S, is filed with the IRS along with the Schedules K-1 that list the income to be reported by the shareholders.

The whole purpose of this scenario is to avoid double taxation of the earnings of your business; once at the corporate level and a second time when you withdraw the earnings. This election can save you quite a bit in taxes.

In order to be effective for a given tax year, the election must be made by the 15th day of the third month of the corporation's tax year. So if your corporation is a calendar year tax filer and you want the election to be effective for 2002, you need to file the election by March 15, 2002. If you file later than that, the election will be effective for the following tax year (2003) and your corporation would still be a regular corporation for 2002.

If you create a new corporation during the year, you must file the election within two months and fifteen days of the first day of the corporation's taxable year. So if you created the corporation on June 1, 2001, you would have to make the election by August 15, 2001 for it to be effective for 2001.


If you have an existing corporation with an established tax yearend, you'll simply have to wait until the following year for your election to take effect. You can simulate the same tax results by making sure you pay out all the corporation's earnings to yourself and the other shareholders before yearend. This would leave you with zero taxable income in the corporation so it pays no tax and all of the earnings would be taxed to the individual owners. However, you might open yourself to an unreasonable compensation claim by the IRS if your corporation's earnings are very high. Also, you will have to be able to estimate your corporation's taxable income very accurately before yearend in order to do this.

If you have a new corporation, you do have another option. A new corporation can adopt any fiscal yearend it chooses with its first tax return. Continuing the example above, if you started your corporation on June 1, 2001 and realized on August 16 that you missed the deadline for filing your S Corporation election, make June 30 your corporate fiscal yearend. File a return for the short period June 1, 2001 to June 30, 2001 and work with your accountants to try to make your expenses and income equal for that one month. There are many accounting methods you can use to do this.

Next, make your election on August 16 for the tax year beginning July 1, 2001 and ending June 30, 2002. Assuming you and the other shareholders are all calendar year taxpayers, you'll have to agree to change the yearend of the corporation to December 31 in order to have your election approved. So you will have a short S Corporation yearend for the period July 1, 2001 to December 31, 2001. Starting in 2002, your corporation will be a full-fledged calendar year taxpayer again.

There is a complete article that deals with this issue in more detail on our website on the Business Articles page.


Many people believe that since they are taxed on the earnings of the S Corporation anyway, they don't need to pay themselves a salary. This is not true. You may get away with it but you are merely playing the audit lottery. What's the difference you may ask? Employment taxes.

The IRS wants you to pay yourself and the other shareholders regular salaries and withhold the required taxes just as though the corporation was a regular corporation. If you are audited, the IRS will assess the taxes you should have withheld based on what they believe reasonable salaries should have been. They will also impose severe penalties for failure to withhold and failure to pay along with hefty interest charges.

Bottom line? Pay yourself and other shareholders who work in the business a salary. You have a lot of leeway as to how much the salaries should be as long as you pay something that you can support as reasonable. The IRS isn't going to be unreasonable with you unless you fail to pay salaries at all.

We hope this information is helpful to you. If you have other questions or require more details, please do not hesitate to let us know.

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