Corporate Pitfalls

Common Pitfalls of Corporations

The Internal Revenue Service (IRS) statistics show that less than 25% of the small business corporations are in compliance with their regulations.  Corporations and in particular S-Corporations are in fact one of the most complicated tax entities.

The following is a general list of the common pitfalls that small corporations make in dealing with the IRS.  These pitfalls put your corporation at risk and can lead to the IRS voiding the corporations’ status or piercing the corporate veil.  If the IRS can pierce the corporate veil or void your corporate status the tax consequences can be catastrophic for the shareholders of the now defunct corporation.  This problem could involve several years of tax returns and increase taxes owed.  Then on top of that problem the IRS will add penalties and interest to the additional tax due, so the amount owed increases exponentially.

Pitfall #1 – Failure to Elect Status for an S-Corporation

  • You must make the election by the 15th day of the 3rdmonth
    • For new S-Corporations
    • For existing C-Corporations electing S-Corporation status
  • The election form must be signed by an Officer of the Corporation
    • It must state in the corporate minutes which officer is to sign the forms.
    • The S-Corporation election form must also be signed by all shareholders agreeing to the elections.

Pitfall #2 – Failure to Keep Minutes

  • The corporation must have at least one annual meeting.
    • Mail agenda to each shareholder before meeting
    • Keep minutes of meeting that clearly show items on the agenda were discussed
  • The corporation can have more meetings if needed or desired.
    • Must have an agenda for each meeting
    • Keep minutes of every corporate meeting
  • Items that must be in the corporate minutes as the need arises.
    • Bank Accounts
    • Loans to and from shareholders
    • Compensation
    • Distributions
    • Any material matter
    • If an S-Corporation, the approval of the election to be an S-Corporation.

 Pitfall #3 – Failure to Separate Personal Assets

  • Corporate veil piercing
    • If you are not acting as a corporation you are not a corporation.
  • Must meet requirements of federal and state law
    • Banking
    • Any state statute
  • Corporation Not a Personal Checkbook
    • You cannot pay personal bills from business checkbook
    • You must not comingle personal and corporate funds.
  • Validity of Corporation Items Paid from Corporate Funds
    • Must have a valid business purpose

Pitfall #4 – Shareholder Loans

  • All loans must meet the requirements to be a legally enforceable loan.
    • Loans from individual shareholder to corporation must be separate
    • Loans to individual shareholders from corporation must be separate
    • Must be documented
    • Must have a due date
    • Must have an interest rate stated
    • Create a repayment plan
    • Problems if not properly substantiated

 Pitfall #5 – Lack of Basis

  • Inside and Outside Basis
    • Inside basis maintained on accounting records of entity
    • Outside basis maintained by shareholder
  • Limitations of Deductibility of Losses
    • Losses greater than basis are not deductible
  • Loan Guarantees Do Not Create Basis
    • Restructuring cannot be retroactive
    • Need for current year-end planning

 Pitfall #6 – Shareholder Compensation

  • Salary must be for services provided
    • Stated and/or reviewed in minutes
    • Personnel policy
  • Salary must be adequate
    • Compensation vs. salary
    • Determination of adequate
  • Must be actually paid
    • Subject to payroll taxes
    • Subject to payroll reporting

 Pitfall #7 – Shareholder Benefits

  • Personnel policy defining benefits
    • Employee driven
    • Health Insurance
      • Reported on W-2 for shareholders
    • HSA Plans
    • Retirement Plans
    • Other personnel policy benefit items

 Pitfall #8 – Failure to Renew Corporation

  • Dissolution & Reinstatement
  • If an S-Corporation
    • S-Corporation status not terminated
    • No new 2553 required
    • No new FEIN required
  • Without Reinstatement
    • Not as clear
    • Taxation determined under federal law

 Pitfall #9 – Distributions

  • Generally not taxable to shareholder
  • If in excess of basis – taxed as capital transaction
    • Must consider inside and outside basis
    • May need to reconstruct prior years
  • Shareholders not automatically entitled to distributions
  • Noted in corporations’ minutes

 Pitfall #10 – Disproportionate Distributions

  • If S-Corporation – second class of stock prohibition
    • Governing provisions and laws
    • Effects on liquidation proceeds
  • Inadvertent and corrective action
  • Non-employee benefits
  • Loans by shareholders treated as second class of stock

 Pitfall #11 – Inadvertent Termination if an S-Corporation

  • Excessive number of shareholders
  • Nonresident alien shareholder
  • Corporation or partnership shareholder
  • Merger into C-Corporation
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