S Corporation Tax Planning Tips
Recent IRS statistics say that S corporations represent the most popular form of small business corporation. That’s understandable. S corporations provide some powerful tax savings benefits for small business owners and investors.
Unfortunately, the S corporation’s extra accounting complexity sometimes means that small business owners don’t get all the savings they’re legally entitled to. To make sure that you don’t miss out on savings, be sure to apply the following tips:
Tip #1: Set a Reasonable But Low Salary
S corporation profits get paid out to the business owners either in the form of salary or profits. In other words, an S corp owner typically receives two types of checks from the business: payroll checks representing wages and dividend checks representing a share of the business profits.
The most important thing an S corporation can do to minimize the tax burden shouldered by the owners is pay shareholder-employees a low though reasonable salary. Here’s why: Paying out profit as wages subjects that money to Social Security taxes and Medicare taxes. In comparison, paying out profits as dividends doesn’t subject the money to Social Security and Medicare taxes.
Example: An S corporation that makes, say, $100,000 in profit before paying the shareholder-employee a reasonable wage would pay roughly $15,000 in Social Security and Medicare taxes if the entire $100,000 is paid as shareholder wages. If only $50,000 is paid as wages, however, the corporation reduces the Social Security and Medicare tax bill from $15,000 to $7,500.
Tip #2: Minimize Distributions
When a small business makes the election to have a corporation or limited liability company treated as an S corporation–both corporations and LLCs can be treated as S corps–the IRS warns about setting shareholder-employee wages too law. That warning also alerts the business about what happens when the salary does happen to be set too low: The IRS can re-categorize distributions made to shareholders (what people commonly refer to as dividends) as wages.
Note: Business owners commonly call the distributions of profit paid out to S corporation shareholders “dividends.” However, just to be technical, in the parlance of corporate tax law, dividends typically get paid by regular C corporations–not by S corporations. S corporations (and partnerships, too) make “distributions” of the profit. But back to the tip of minimizing distributions…
The IRS ability to re-categorize distributions as wages means that, to the extent possible, you may as well minimize distributions of profit to shareholders. In other words, don’t distribute money to shareholders simply because you can. For example, if shareholders will save the money (say for working capital purposes or for a new business investment), just save the money inside the S corporation–not outside the corporation.
Example: If a corporation makes a $100,000 profit and pays out half of this money, or $50,000 as wages and the other half or $50,000 as distribution, the IRS may be able to re-categorize some or all of the $50,000 distribution as wages. If the corporation pays only a $30,000 distribution, in the worst-case scenario the IRS can probably only reclassify the $30,000 as wages.
In the end, by minimizing distributions, the S corporation minimizes the money that can theoretically be reclassified as shareholder-employee wages.
Tip #3: Move Deductions to the S Corporation Tax Return
A final easy tip can often be employed by the small business corporation using the Subchapter S rules. You can often move tax deductions from the shareholder’s 1040 tax return to the corporation’s 1120S corporation tax return.
Moving deductions from an individual tax return to the corporation tax return may not save the shareholder-employee and S corporation owner income taxes. After all, the deduction represents a deduction on both tax returns. But the benefit of moving a tax deduction to the corporation return is that deduction then naturally reduces the distributions made to shareholders.
Example: Suppose an S corporation makes $100,000 in profits before paying the shareholder-employee wages. Further suppose that the shareholder-employee purchases individual health insurance for his family at an annual cost of $10,000, annually saves $5,000 for retirement and makes $5,000 annual charitable contributions. If these deductions are paid by the corporation rather than by the individual, the shareholder finds himself in the same economic position. But now the S corporation is paying out $80,000 in wages and distributions to the shareholder-employee rather than $100,000.
S-Corporation Tax Structure Could Be Beneficial
If you have incorporated your business and decide to become an S Corporation, you should know the main difference between S and C is the corporation’s tax structure.
Once you incorporate your business, you will have to decide within about two and a half months whether you want to remain a C Corporation or file a form 2553 with the IRS to become an S Corporation.
In an S Corporation, the shareholders are taxed like a partnership or sole proprietorship. In other words, an S Corporation avoids the “double taxation” of C Corporations in which taxes are paid by shareholders and the corporation itself. In a C Corporation, shareholders report income from the corporation on their 1040 form.
The S Corporation still must file a federal tax return, but the corporation itself does not pay taxes.
Once a C Corporation is formed, the corporation itself is unchanged, but the way it is taxed does—at least in most states. Some states do require S and C corporations to file taxes the same way, so you must know your state law when determining whether to choose an S corporation for your company status.
S Corporations do have some restrictions that C Corporations do not. For example, the company must be incorporated in the United States, it cannot have foreign shareholders, it cannot have more than 100 shareholders, and all shareholders must be individuals.
The S Corporations has some clear tax advantages in addition to avoiding, in most cases, double taxation. One of those is that any losses the corporation incurs can be taken against income on personal tax returns.
The S Corporation was designed for small businesses that require more structure than afforded by partnerships or even LLCs.. To determine whether an S Corporation structure is the best fit for your company, you must carefully examine the benefits and disadvantages of such a structure before making such an important decision.