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 Errors You Don’t Want To Make
According to the IRS, S corporations now outnumber regular corporations.
The popularity of Subchapter S corporations shouldn’t really surprise people, however. S corporations provide two big tax savings to small business owners. First, they typically don’t pay federal or state corporate income taxes.
And, second, S corporations often minimize the payroll taxes that S corporation shareholder-employees pay because only amounts the corporation designates as wages get taxed for Social Security and Medicare tax purposes. Unfortunately, S corporation owners make some common tax blunders–blunders that can destroy or delay the tax savings the S corporation option should deliver.
Blunder 1: Late Sub S Elections
The first blunder? Thinking you can make the S election at the end of the year. An S election needs to be made early in the year or before the year even starts in order to be effective for the year. Specifically, you should make the S election either before the year starts or within 75 days after the start of the new year.
For a business whose tax year begins on January 1, the election needs to be made by March 15. If a new business begins life mid-year on, say, May 23, the 75-day counter starts ticking down from that date.
Note: The IRS does provide a mulligan for people who miss the election deadline. Taking this mulligan, however, requires that you strictly follow some “late S election relief” procedures. Accordingly, you probably want to get a CPA’s help with this.
Blunder 2: Forgetting Shareholder-employee Payroll
When you make a successful S election, the Internal Revenue Service sends your business an approval letter. That letter uses scary–almost threatening language–warning you to pay reasonable compensation to shareholder-employees.
Despite the warning, S corporations commonly forget to do the formal payroll thing–including regular payroll checks and tax deposits, quarterly payroll tax returns, and year-end W-2s. That’s often a huge mistake.
If you don’t do payroll, the IRS will catch up with you. At that point, the IRS will re-categorize all of the shareholder-employee draws as wages. This re-categorization may trigger thousands of dollars of back taxes, penalties and interest for each year and for each shareholder-employee for whom you forgot to do payroll.
Accordingly, you got to do payroll. Period.
Blunder 3: Bad Borrowing Habits
Ironically, your bank often helps you make another common S corporation tax blunder: The bank will loan you money to buy some piece of equipment–or perhaps a business vehicle.
But the bank often lends its money directly to your S corporation. As crazy as it sounds, the bank should loan the money to you personally and then you should loan the money to the S corp.
An awkward problem exists when a business loan gets used to fund an S corporation purchase. You get to write off your purchase only when you have at least that much basis in the S corporation. Yet you only get basis from money you’ve personally invested in or personally loaned to the corporation.
You don’t get basis from a loan made to your S corporation for, say, a new delivery vehicle purchased for the business. Without basis, you often won’t be able to deduct the purchase on your tax return.
This S corporation tax mistake gets made all the time–often when S corporation owners are making last minute, year-end asset purchases to drive down their income.
Fortunately, you can solve the problem pretty easily. Make sure you directly borrow the money for asset purchases and then do a back-to-back loan to your corporation.
This back-to-back loan shouldn’t increase your risks. You’ll probably have to personally guarantee the loan anyway, right?
Blunder 4: Triggering the BIG Tax
Typically, S corporations don’t pay federal income taxes. That’s a huge part of the attraction. A couple of common exceptions to this general rule exist for S corporations that started life as regular C corporations.
The first exception? The “built-in gain” or BIG tax. It applies to profits recognized by the S corporation but stemming from the time when the corporation operated as a C corporation.
The details of the built-in gain tax get boringly tedious. But logic is really simple. If you would have paid tax on some income or gain had you still been a regular C corporation and that income or gain was already “locked in” at the point you converted from a C corporation to an S corporation, the old C corporation tax (35% of profits) still applies.
The moral: You need to be really careful if you convert to S corp status after operating as a C corporation. Make sure your accountant understands and helps you minimize the BIG tax.
Blunder 5: Passive Income Excesses
Another tax blunder threatens S corporations previously operated as C corporations, too.
If an S corporation profitably operated as a C corporation and has retained some of those profits, passive income (interest, rents, dividends and so forth) gets taxed when it exceeds 25% of gross receipts.
This “too much passive income” problem may sound only theoretical. But it occurs regularly with old S corporations being wound down by the owners–say for retirement.
If an S corporation that used to be a C corporation metamorphoses from an operating company to an investment company, at some point, the S corporation may pay corporate income taxes.
If that isn’t bad enough, yet another problem exists with turning an S corporation that used to be a C corporation into an investment holding company. If the passive income crosses over the 25% threshold for three years in a row, the S corporation status terminates.
Because of the taxes on excessive passive income and the risk of losing S status, avoid or minimize passive income within an S corporation that previously operated as a C corporation. One easy way to do this is to distribute profits to shareholders rather than reinvest them.