A Texas company set up as an S-corporation typically passes income through to its shareholders, who claim the income on their personal tax returns. However, S-corporations can still be affected by taxes due to regulations that dictate how they must do business, and also depending on the state where they do business.
State requirements vary
Most states follow the same tax rules for S-corporations based on federal requirements. However, states like New Hampshire, Tennessee and Texas do not follow these rules and instead tax S-corporations the same as if they were C-corporations. Business owners must ensure they follow the appropriate tax law and relevant requirements for their state or risk being subject to a tax audit.
A business owner who is also a shareholder and company employee, as most business owners are, in an S-corporation receives their share of the company’s profits through distribution, and they are not required to pay taxes on this amount. However, the IRS does not allow business owners to work for zero salary and receive all their compensation in a distribution.
Tax laws require owners to receive a salary from the company that equates to someone doing similar work in a comparable company. The salary is recorded on the company’s profit and loss statement, which reduces its net income. This requirement may create an additional financial burden if the company struggles financially.
Tax regulations and company ownership
S-corporations must contend with specific U.S. tax regulations that restrict business ownership. If they want to provide equity ownership to raise additional capital, the business is limited to a maximum of 100 owners. Tax regulations for S-Corporations also require all owners to reside in the U.S. or be American citizens, which could create challenges for businesses whose important business relationships are mainly outside of the country. C-Corporations have no such limitations.
Poor record-keeping and underpaying taxes
Sometimes, S-corporations are small businesses that lack the resources to have a department dedicated to keeping detailed tax records to ensure they pay the proper amount. This need is relevant for companies in states like California, which imposes a 1.5% franchise tax on S-corporations’ income.
Small companies also collect sales tax from customers and may neglect to file and pay their state’s tax returns. At tax time, these companies may have financial penalties and interest due in addition to their tax liabilities if they do not calculate correctly and pay on time.
S-corporation tax issues deserve attention and planning. Staying informed of state and federal requirements, recording transactions properly, and filing taxes promptly can help business owners avoid audits and other tax issues.