If you recently started a business and are considering changing your LLCs or C corporations from the entity’s default tax treatment to S corporation election, now is a great time to remind you about the pitfalls to avoid when making that transition. Here, some common mistakes many people make when switching to S corporation tax treatment and how to avoid them.
- Missing their filing deadline
Many clients might not realize the federal government will not grant an S corporation election at just any time. To help you avoid a delay in getting S corporation tax advantages we are informing you of the deadlines for submitting the IRS Form 2553. to get S corporation tax treatment for tax year 2026: Existing LLCs and C corporations with a calendar tax year (i.e., Jan. 1 to Dec. 31) must file Form 2553 by March 16, 2026.
- Existing LLCs and C corporations that follow a different fiscal year have until two months and 15 days after the start of their fiscal year to file Form 2553.
- New LLCs or C corporations have two months and 15 days from their date of formation or incorporation to file for S corporation tax treatment.
If you miss their deadline, the S corporation election will be effective the following tax year unless you request and are granted relief for a late election.
- Neglecting to check their entity’s eligibility
Educate new entities and their shareholders or members about the S corporation eligibility restrictions so you do not waste time, energy and money on filing for the election if your company does not meet the IRS’s qualification criteria:
- Be a domestic corporation (or other entity eligible to be treated as a corporation);
- Have only allowable shareholders (individuals, certain trusts and estates); partnerships, corporations and nonresident alien shareholders are not permitted;
- Have no more than 100 shareholders;
- Have only one class of stock;
- Cannot be an ineligible corporation, such as certain financial institutions, insurance companies, and current or former domestic international sales corporation;
- Have a tax year ending on Dec. 31 or meet the qualifications (or obtain approvals) for using a different fiscal year.
- Failing to set up payroll
Business owners who are hands-on in the business’s operations must take the necessary steps to set up payroll to pay themselves and other owner-employees actively working in the business. You must set various payroll tax accounts, as well as the withholding reports and remittance schedules that will be needed to keep track of payroll. Employment laws are fairly strict and must be followed or there could be severe penalties. Naturally, this can create a learning curve for business owners who are accustomed to taking owner’s draws from the company’s bank account, so you will likely need to guide them through the process or direct them to another resource who can address their needs.
- Ignoring the reasonable compensation rule
This is a slippery slope for business owners. Sure, who doesn’t want to minimize their tax burden? Try not to game the system. If an owner employee takes an unreasonably low salary and compensation for themselves with disproportionately high distributions to lessen their Social Security and Medicare tax obligations, they will put themselves at great risk. Failure to pay reasonable compensation may lead to IRS penalties and reclassification of distributions as wages, with back taxes owed. The IRS requires S corporation shareholder-employees to pay themselves a “reasonable salary” for the work they perform. Reasonable compensation is based on industry standards, job duties, experience, and comparable wages for similar work. For example, suppose a similar position in your client’s field earns $80,000 annually, but your client decides to pay themselves only $20,000 while taking the remainder of the company profits as distributions. The IRS would likely become suspicious. While no exact formula exists for determining reasonable compensation, many accountants recommend allocating 40% to 60% of net income to salary. However, emphasize to your clients that the actual figure they decide on should be supported by data.
- Not knowing about the 2% rule
Whereas employees in C corporations may receive fringe benefits tax-free, this is not the case for S corporation shareholders who own more than 2% of their company. Benefits such as health insurance premiums must be reported as taxable wages on those shareholders’ W-2 forms. This rule is designed to prevent small groups of owners from avoiding payroll taxes through untaxed benefits. The 2% rule helps prevent S corporation owners from avoiding payroll taxes via untaxed benefits.
- Not checking to see if the state requires an S corporation election filing
Do not assume that your S corporation election at the federal level will automatically give them similar pass-through tax treatment at the state level. While most states recognize the federal S corporation election and automatically apply it, some do not acknowledge it or require additional steps or filings to honor it in their jurisdiction.
States requiring a state-level S corporation or other filing
- New Jersey entities authorized to conduct business prior to Dec. 22, 2022, must file an SCORP application to be treated as an S corporation for N.J. tax purposes. Entities authorized to conduct business on or after Dec. 22, 2022, must show proof of their federal S corporation status and submit a Shareholder Jurisdictional Consent form.
- New York entities (except in New York City) must file Form CT-6 to allow individual shareholders to report corporate income on their individual state tax returns.
- As of Jan. 1, 2026, Louisiana accepts the federal election and does not subject S corporations to franchise tax. (Prior to Jan. 1, 2026, Louisiana S corporations were subject to franchise tax. Also, all shareholders who were Louisiana residents were required to exclude their portion of income and expenses on the corporate tax return and include them on their Louisiana individual income tax returns. In addition, nonresident shareholders had the option of electing to file individual nonresident and part-year resident Louisiana tax returns for their portion of the income and expenses or have the corporation pay the taxes at the corporate income tax rate for their portion of the income.)
- Georgia accepts the federal S corporation election, but nonresident shareholders must file Form 600S-CA to acknowledge their agreement to pay Georgia income tax on their proportionate part of the corporation’s taxable income.
- Mississippi requires Form 84-380 to confirm nonresident shareholders’ agreement to pay Mississippi taxes on their proportionate part of the corporation’s taxable income.
Jurisdictions that don’t provide pass-through tax treatment to S corporations
- New York City
- District of Columbia
- New Hampshire
- Tennessee
- Texas
Time is of the essence
As this year’s S corporation election deadline approaches for newly formed business entities, now is the time to make that election on or before MARCH 15, 2026. You may require some additional help making that election and all the other aspects that are critical to making a Sub S election to help you navigate past the hazardous bumps in the road and lead you on a smooth journey as you start and grow your businesses.