Setting up an S Corporation can be a smart move for entrepreneurs seeking tax advantages and liability protection. However, the process involves more than just filing paperwork. Many business owners unknowingly make critical mistakes that can lead to IRS penalties, compliance issues, or even loss of S Corporation status. In this guide, we’ll explore the top 10 mistakes to avoid when forming your S Corporation, helping you start strong and stay compliant.
1. Failing to File IRS Form 2553 on Time
One of the most common mistakes is neglecting to file Form 2553 with the IRS to elect S Corporation status. This form must be submitted within 75 days of incorporation or the beginning of the tax year. Missing this deadline means your business will be taxed as a C Corporation, potentially leading to double taxation.
2. Choosing an Ineligible Entity Type
Only domestic corporations and certain LLCs can elect S Corporation status. Partnerships, foreign entities, and some trusts are not eligible. Before filing, confirm that your business structure qualifies under IRS rules to avoid rejection.
3. Exceeding Shareholder Limits
S Corporations are limited to 100 shareholders, and all must be U.S. citizens or resident individuals. Including non-resident aliens, corporations, or partnerships as shareholders will disqualify your S Corporation status. Always verify shareholder eligibility before issuing shares.
4. Issuing Multiple Classes of Stock
S Corporations are only allowed to issue one class of stock. Offering preferred shares or creating different voting rights can violate IRS rules and result in termination of your S Corporation election. Keep your stock structure simple and uniform.
5. Ignoring State-Level Requirements
While S Corporation status is a federal tax designation, you must still comply with state-level incorporation laws. This includes filing Articles of Incorporation, appointing a registered agent, and submitting annual reports. Failing to meet state requirements can lead to fines or administrative dissolution.
6. Not Paying Yourself a Reasonable Salary
Owners of S Corporations often try to minimize taxes by taking distributions instead of salaries. However, the IRS requires that shareholder-employees receive a reasonable salary for services rendered. Underpaying yourself can trigger audits and penalties. Use industry benchmarks to determine fair compensation.
7. Poor Record-Keeping and Corporate Formalities
Unlike LLCs, S Corporations must follow corporate formalities, including holding annual meetings, maintaining minutes, and documenting major decisions. Neglecting these practices can weaken your liability protection and raise red flags during audits.
8. Mixing Personal and Business Finances
Commingling personal and business funds is a serious mistake that can pierce the corporate veil. Always maintain separate bank accounts, credit cards, and financial records to preserve your S Corporation’s legal protections.
9. Misclassifying Workers
Incorrectly classifying employees as independent contractors can lead to tax liabilities and legal issues. S Corporations must comply with federal and state labor laws, including payroll taxes and workers’ compensation. Review IRS guidelines to ensure proper classification.
10. Overlooking Ongoing Compliance Obligations
Forming an S Corporation is just the beginning. You must stay compliant with annual filings, tax returns, and shareholder updates. Missing deadlines or failing to file required documents can result in penalties or loss of good standing. Set up reminders and use professional support when needed.
Conclusion
Avoiding these common mistakes when setting up your S Corporation can save you time, money, and legal headaches. From filing IRS Form 2553 on time to maintaining proper records and paying yourself fairly, each step plays a vital role in your business’s success. By staying informed and proactive, you’ll ensure your S Corporation remains compliant, tax-efficient, and ready to grow.
If you need help reviewing your setup or preparing documentation, I can walk you through it step-by-step. Just let me know how you’d like to proceed.
