Compliance
Common S Corp mistakes to avoid.
The S Corp election saves real money — but only when you follow the rules. These nine mistakes trigger IRS penalties, void your tax savings, or both.
01 · Salary
Setting your salary too low
The whole point of the S Corp election is to split compensation into W-2 salary and distributions — distributions are not subject to FICA. But setting your salary artificially low is the single most common audit trigger.
The IRS evaluates salary reasonableness based on your role, hours, industry, and comparable compensation. If your S Corp is a consulting firm generating $300K and you pay yourself a $20K salary while taking $280K in distributions, expect a reclassification. The IRS will re-characterize distributions as wages, and you will owe back payroll taxes plus penalties.
Penalties
- · 20% penalty on underpayment of FICA
- · 1.5% of unpaid wages per Forms 941 not filed on time
- · Trust Fund Recovery Penalty — up to 100% of unpaid trust fund taxes
- · Interest accrues from the original due date
02 · Filing deadline
Missing the Form 2553 deadline
Form 2553 (Election by a Small Business Corporation) must be filed by March 15 of the tax year you want the election to take effect — or within 75 days of forming the entity. Miss that window, and you may have to wait a full year before the S Corp election kicks in.
Late elections are possible under Rev. Proc. 2013-30. You must demonstrate reasonable cause, attach a statement to your delinquent Form 2553, and file it with your first return. The IRS has granted relief in cases where taxpayers mistakenly filed as C Corps or simply did not know about the deadline — but it is not guaranteed.
Timeline
- · Standard deadline: March 15 of the desired tax year
- · New entity: 75 days from formation
- · Late election relief: File Form 2553 with first return
- · Missing relief: Wait until the next tax year
03 · Payroll
Not running payroll at all
Some S Corp owners treat all business income as distributions — no W-2, no payroll, no employment taxes. This is incorrect. If you are a shareholder who works for the S Corp, you must be paid a reasonable W-2 salary. Distributions are a separate concept from compensation.
Without payroll, the IRS can assess back FICA on all distributions, disallow business deductions tied to payroll taxes, and impose penalties on missing Forms 941, 940, and W-2. The S Corp also loses the employer-side FICA deduction, and the shareholder loses the retirement plan contribution limit that is tied to W-2 wages.
Missing filings
- · Form 941 (quarterly payroll tax)
- · Form 940 (FUTA annual)
- · W-2 (year-end wage statement)
- · State withholding and unemployment returns
Consequences
- · All distributions reclassified as wages
- · 15.3% FICA owed on full amount
- · Penalties for unfiled Forms 941
- · Lost retirement plan contribution capacity
04 · Form 1120-S
Failing to file Form 1120-S on time
Form 1120-S is due March 15 — the 15th day of the 3rd month after the close of the tax year. This is a month earlier than individual returns. Filing an extension (Form 7004) gives you more time to file, but not more time to pay. If you owe tax, interest accrues from March 15 regardless.
Late-filing penalty
$220 per shareholder per month, up to 12 months. For a single-owner S Corp: $220/month. For a 5-owner S Corp: $1,100/month. The penalty starts accruing the day after March 15 and is not waived by an extension.
If Form 1120-S is not filed by the deadline, the S Corp's pass-through status can be jeopardized. A late return may cause the election to terminate for that year, converting the entity to a default C Corp for federal tax purposes — triggering corporate-level tax on all income.
05 · Corporate veil
Mixing personal and business finances
An S Corp provides liability protection — but only if you treat it as a separate entity. Using the corporate bank account for personal expenses, paying personal bills from business funds, or failing to maintain separate accounts can "pierce the corporate veil."
When the corporate veil is pierced, a court can hold you personally liable for the corporation's debts and obligations. This defeats the entire purpose of forming an S Corp. In the tax context, the IRS may also disallow deductions where personal and business expenses are commingled.
Best practices
- · Maintain a dedicated business bank account
- · Never pay personal expenses from the business account
- · Use a business credit card for business purchases
- · Transfer personal funds to the business account before paying bills
06 · State filings
Forgetting state-level filings
Filing your federal Form 1120-S does not satisfy state requirements. Every state where your S Corp does business (or is formed) has its own tax or franchise return. Failing to file these returns triggers penalties separate from federal ones.
California
1.5% franchise tax on net income, minimum $800. S Corps are not exempt from the $800 minimum.
New Jersey
Corporate Business Tax (CBT) at 6.5%–11.5% depending on net worth. S Corps file CBT-100S.
New York
Article 9-A filing required. S Corps may owe the fixed dollar minimum tax based on receipts.
States like Texas and Washington impose gross receipts taxes (no income tax) that apply to S Corps. Always check where you have nexus and what returns are due.
07 · Records
Not keeping corporate minutes or records
An S Corp is a corporation. Corporations must hold annual shareholder meetings, document major decisions in meeting minutes, and maintain a corporate record book. Skipping this step does not save time — it creates liability exposure.
Courts look at whether you maintained corporate formalities when deciding whether to pierce the corporate veil. If you cannot produce minutes, resolutions, or evidence of separate entity treatment, you lose the liability shield. The IRS may also view the absence of corporate records as evidence the S Corp election is not genuine.
Records to maintain
- · Annual shareholder meeting minutes
- · Board resolutions for major decisions
- · Stock ledger and share certificates
- · Separate bank account statements
- · Payroll records and tax filings
08 · QBI deduction
Ignoring the QBI deduction interaction
The §199A qualified business income deduction lets S Corp shareholders deduct up to 20% of their qualified business income. For many owners, this is a five-figure tax benefit. But it does not exist in isolation — it interacts directly with the salary you set.
The QBI deduction is subject to a W-2 wage limitation for taxpayers above certain income thresholds. Your S Corp's W-2 wages (paid to you) are used in the wage-limitation calculation. Setting salary too low can reduce or eliminate the QBI deduction when your income exceeds the threshold. The interplay between salary, distributions, and QBI requires careful planning.
Key interaction
- · QBI deduction = up to 20% of qualified business income
- · W-2 wage limitation applies above income thresholds
- · Higher salary = higher wage limit = larger potential QBI deduction
- · Balance: enough salary for QBI, not so much that FICA outweighs the benefit
09 · Annual review
Not reviewing reasonable salary annually
A salary that was reasonable in year one may become unreasonable as your S Corp grows. If your revenue doubles and your responsibilities expand, the IRS expects your compensation to reflect that. A salary frozen at $50K while profits grow to $500K is a red flag.
Review your salary at least annually with a tax advisor. Consider your role, hours worked, comparable salaries at similar companies, and the current profit level. This is especially important if you have added employees or taken on new responsibilities.
Factors to review
- · Hours worked per week
- · Responsibilities and scope
- · Industry salary benchmarks
- · Company profit trends
When to adjust
- · Annual profit growth exceeds 20%
- · You hire employees or take on new roles
- · Your industry experiences wage inflation
- · You receive new certifications or licenses
FAQ
Frequently asked questions
What happens if I pay myself too low a salary as an S Corp owner?
The IRS can reclassify your distributions as wages, requiring you to pay back payroll taxes plus penalties and interest. Penalties can include 20% of the underpayment for failure to deposit, 1.5% of unpaid wages for failure to file Forms 941, and potential Trust Fund Recovery Penalties of 100% of unpaid trust fund taxes. There is no bright-line salary threshold — the IRS evaluates reasonableness based on your role, industry, and hours worked.
Can I file Form 2553 late if I missed the deadline?
Possibly. The IRS provides late-election relief under Rev. Proc. 2013-30 if you have reasonable cause for missing the deadline. You must file the delinquent Form 2553 with a statement explaining the reasonable cause, and attach it to your first tax return filed after the intended effective date. If relief is granted, the S Corp election is treated as if it had been timely filed. Deadlines matter — the standard rule is 75 days before the start of the tax year.
Do I have to run payroll if I'm the only S Corp owner?
Yes. If you work for your S Corp, you must pay yourself a reasonable W-2 salary and run payroll. The S Corp must withhold federal income tax, Social Security, and Medicare taxes, file Forms 941 quarterly, and issue a W-2 at year-end. Treating all income as distributions — with no W-2 — is a major audit trigger.
What is the penalty for filing Form 1120-S late?
The IRS charges $220 per shareholder per month for filing Form 1120-S late, with a maximum penalty of 12 months. For a single-owner S Corp, that's $220/month. For a 5-owner S Corp, it's $1,100/month. The penalty begins accruing the day after the March 15 filing deadline. Filing an extension (Form 7004) does not eliminate the penalty — it only extends the time to file, not the time to pay.
How does the S Corp election affect the §199A QBI deduction?
S Corp shareholders can claim the §199A qualified business income deduction on their share of pass-through income, potentially deducting up to 20% of QBI. However, the deduction interacts with your W-2 salary — the W-2 wages paid by the S Corp are used in the W-2 wage limitation calculation for the QBI deduction. Setting salary too low can reduce your QBI deduction if your income exceeds the threshold. Consult a tax advisor to optimize the salary vs. distribution split for QBI purposes.
Does every state require a separate filing when I form an S Corp?
Yes. In addition to your federal Form 1120-S, most states require a separate income tax or franchise tax return. California charges a 1.5% franchise tax (minimum $800), New Jersey has the Corporate Business Tax (CBT), and New York requires Article 9-A filing. Some states — like Texas and Washington — impose a gross receipts tax regardless of S Corp status. Always check your state's specific requirements.
Should I review my S Corp salary every year?
Absolutely. As your S Corp's profits grow, the salary you set initially may become unreasonable relative to your role and industry. The IRS considers factors like your hours worked, responsibilities, comparable salaries at similar companies, and your experience. A salary that was reasonable at $100K profit may be too low at $400K profit. Review annually with a tax professional.
Related reading
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How to Elect S Corp Status
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Model your S Corp numbers before you make a mistake.
The BizTaxMetrics calculator models the salary-vs-distribution split, self-employment tax savings, and QBI deduction impact — so you can set a defensible salary and avoid the mistakes that cost real money.