This is the second part of a two-part look at the most common misconceptions concerning S-corporations. As we learned in Part 1, the S-corp isn't an entity. It is a tax designation granted by the IRS.

In this companion piece, we'll look at some of the implications of that designation, as well as how an S-corp election alters your standing in your company.

Misconception #4: An S-Corp Election = Tax Savings

The number one reason business owners consider an S-corp election is to save on taxes.

But let's be clear: you might save on taxes, but you might not. It depends on your business.

An S-corp election can lower tax in two ways:

  • By eliminating corporate tax by making your company a pass-through entity
  • By allowing you to distribute profits as dividends which are taxed at a lower rate

Let's say you have a company that generates $40,000 in income. With S-corp status, you pay yourself a reasonable salary ($30,000) and distribute the remaining profit as qualified dividends ($10,000). Your wages are subject to self-employment taxes (13.3% in 2016), since you are both the employer and the employee.

This scenario is how the S-corp is usually presented. What gets left out is that in order to pay yourself wages, you have to set up payroll. Either you do this yourself, or you hire someone to do it for you. Either way, there is an expense, either in time or money. It makes little sense to gain S-corp status to save on taxes if you spend more money on a payroll service than you actually save in taxes.

In reality, there are numerous factors involved in calculating taxes, from the level of your wages to the losses you deduct to any loans you take on during a fiscal year. In some cases, for example, it would be better to pay taxes as a regular corporation, because corporate tax rates are generally lower than personal income tax rates.

To determine whether or not an S-corp election will save you on taxes, you should meet with a tax professional who can fully evaluate your financial situation and properly advise you.

Misconception #5: The IRS Doesn't Care How I Determine Compensation

An S-corp alters how you compensate your shareholders. You are required to pay shareholders a reasonable salary, and you are allowed to distribute company profits in the form of dividends.

The sticky wicket is reasonable salary. A reasonable salary is one that is relatively in line with the salaries of others in your industry performing the same work.

The IRS allows you to set salaries and allocate dividends, but S-corps often come under scrutiny during tax season. The IRS may disagree with your numbers and decide to reclassify them.

Let's say you are the sole shareholder in your company. You pay yourself a salary of $40,000 and in your most recent fiscal year you allocated to yourself $20,000 in dividends.

But the IRS reviews your numbers and decides you made a mistake. It determines that you should have paid yourself $50,000, and thus it reclassify $10,000 of your dividends. Now you must recalculate the tax you owe based on a $50,000 salary and $10,000 of dividends.

Since capital gains taxes are considerably lower than income taxes, this shift will mean an overall loss.

On the other hand, if your company was incredibly profitable, and the reasonable salary in your industry is relatively low, then your tax savings could be considerable. For example, if you generated $200,000 in profits and your reasonable salary level was $50,000, then the remaining $150,000 could be distributed as a dividend, a very significant savings.

Misconception #6: An S-Corp Shareholder is Just Like a Corporation Shareholder

An S-corp election fundamentally alters your standing in your company. Instead of being merely a shareholder, you are now both an owner and an employee. This distinction puts your overall ownership share constantly in flux. To understand how, you must understand Basis.

Basis calculates the amount of your investment in your business. At the start, it is determined by evaluating the amount of cash paid for shares of the company, any property or assets contributed to the business, and the value of stock at the time of conversion.

In the example above, your initial $10,000 investment was your basis in the company.

Basis increases through capital contributions, ordinary income, investment income and gains. Basis decreases through deductions, charitable contributions, nondeductible expenses and distributions.

Your basis determines how much you can withdraw/receive from the business without it being considered income or capital gains.

Basis also determines what you can deduct in losses. In the previous example, you could only deduct $10,000 because that was your (vastly simplified) basis in the company. Anything deducted above that number gets counted as income or capital gains.