The S-Corporation is the entity of choice for many small businesses because it combines the liability protection of a corporation with some of the key tax benefits of a partnership or LLC, and it is, in most circumstances, by far the best entity for savings on payroll taxes / self-employment taxes. The S-corporation income tax return is IRS Form 1120S and the S-corporation election is made on IRS Form 2553.
S-Corporations FICA / Self-Employment Tax Savings
According to S-Corporation tax consultant San Diego CPA Michael Fitzsimmons, significant tax savings can be achieved by running a business through an S-corporation (including an LLC that has elected to be taxed as an S-corporation) and taking a salary that is lower than the amount of "profits before owner salaries". This is because FICA (Social Security & Medicare) taxes (which are equivalent to the self-employment taxes paid by sole proprietors, LLC members, and general partners) are payable on income taken as salary, but not on income left in the corporation or taken as S-corporation distributions (sometimes referred to as "dividends", which is incorrect, because technically dividends are paid by out of C-corporation earnings and profits).
However, a lower salary will result in higher California S-corporation net income tax if the remaining corporate net income exceeds $53,333. The additional California S-corporation net income tax is 1.5% of any profits (after owner salaries) that exceed $53,333. Therefore, taking lower owner salaries results in significantly lower FICA taxes but slightly higher California S-corporation income taxes.
While payroll taxes and California S-corporation income taxes vary depending on how much of the net income is taken as salary, personal income taxes do not. Shareholder-owners are liable for personal income taxes on amounts taken as salary plus on the corporation’s remaining net income at the same rates. In fact, the net income of an S-corporation or LLC is taxed to the owners regardless of whether it is distributed to them.
The net tax savings achieved by taking a lower salary is calculated as follows:
Decrease in payroll taxes (primarily FICA*)
* FICA taxes on the first $110,100 (2012) of salary per employee per year are nominally 15.3%; they are nominally 2.9% on any additional salary. In both cases the taxes are paid 50% by the employee through paycheck withholding and 50% by the corporation (7.65% and 1.45% each, respectively). Note that for 2011 & 2012 the "Payroll Tax Holiday" economic stimulus reduced the employee Social Security withholding to 4.2% instead of 6.2%, and the Self-Employment tax to 13.3% instead of 15.3%.
– Increase in California net income tax
= Tax Savings
Besides the net tax savings from taking a lower salary, the following additional issues should be considered:
Non-Tax Costs Of Forming And Running The Corporation
Non-tax costs of forming and running the corporation include attorney and filing fees, business entity tax ($800 per year in California), preparation of corporate tax returns, payroll service. Corporate accounting books and income tax return preparation should be prepared/reviewed by an experienced S-Corporation tax consultant, such as San Diego CPA Michael Fitzsimmons.
Reasonable Shareholder Compensation
Each shareholder (and spouse of a shareholder (deemed a shareholder for most tax purposes by virtue of being married to the actual shareholder)) must take a salary that is reasonable for the work s/he performs for the corporation.
In a United States Treasury report titled "The Internal Revenue Service Does Not Always Address Subchapter S Corporation Officer Compensation During Examinations" the Treasury reported that their analysis of 84 S-corporation returns that had been audited by the IRS showed average officer wages of $5,300 and average distributions of $349,323. The report concluded that S-corporations were paying low wages to shareholders in order to minimize FICA tax and that the IRS was not addressing the understatement of tax in an aggressive manner.
In response to this report, in 2003 the IRS announced its intention to pursue S-corporations that pay unreasonably low salaries to shareholders. They now include this warning in each letter of acceptance to be taxed as an S-corporation: "When a shareholder-employee of an S Corporation provides services to the S corporation, reasonable compensation generally needs to be paid."
If non-salary transactions (distributions a.k.a dividends) are later recharacterized as salary, the corporation will become liable for back taxes, interest, and penalties. Further, anyone who is a "responsible person" (corporate officers and persons who have authority to sign checks) may be liable for a portion of the back taxes, interest, and penalties in the event the corporation has dissolved or does not pay. Other tax authorities, such as the California Employment Development Department (EDD) may also assess back taxes, penalties, and interest.
What is reasonable compensation is not clear-cut; there are no black-and-white rules. What is reasonable is based on such factors as compensation paid to non-shareholders performing similar work in similar businesses ("comps" a.k.a. "comparables") and fair return on capital invested (amounts paid for stock in the corporation and additional paid-in capital invested. Earnings as a sole proprietor before incorporating have been held as an indication of a reasonable amount of salary (this argument is economically unsound, but has nonetheless been used with some success by various tax authorities seeking to recharacterize S-corporation distributions as salary).
In order to collect more payroll taxes, the tax authorities want to characterize the money that owners take out of their S-Corporations as salary. To help prevent this, you need to make your S-corporation distributions not look like salary. An experienced S-Corporation tax consultant, such as San Diego CPA Michael Fitzsimmons, can assist in designing and implementing accounting formalities and tax return presentation regimens to strengthen your position in regards to this issue.
Retirement Plan Contributions
The amount of money that a person can contribute to tax-advantaged retirement savings accounts, such as a 401(k), SEP-IRA, SIMPLE IRA, or defined benefit plan, is based on the amount of "earned income”" Earned income includes only salary and self-employment income, and does not include S-corporation net profit or S-corporation distributions. Earned income also does not include such things as interest, dividends, capital gains, rental income, or retirement income. However, an experienced S-Corporation tax consultant, such as San Diego CPA Michael Fitzsimmons, can assist in choosing the best retirement plan and the ideal provisions to maximize contributions and tax savings for owners while minimizing costs and contributions for rank-and-file employees. Under the right circumstances and with proper planning, a small business owner can contribute more than $25,000 per year to his or her 401(k) on a salary of only $50,000 per year!
Social Security Benefits
Social Security benefits depend on how much "earned income" a person has during his or her working years. By using an S-corporation and taking a salary that is less than the amount of net income that would be reported if doing business as a sole proprietor, and also less than the "Social Security Ceiling" ($110,100 in 2011), the amount of Social Security benefits earned will be lower. Note that Social Security benefits are not limited to retirement, but also include benefits in the event of disability or premature death of a worker. At http://www.ssa.gov you can download free software that will assist you in determining the likely effect of this strategy on any Social Security Benefits you or your survivors may eventually receive (…if you believe that the government will have any Social Security money left by the time you retire).
Qualified Small Business Stock
Under Internal Revenue Code Section 1202, there is generally no tax on some or all of the gain from selling Qualified Small Business Stock (QSBS), which is stock in a small business C-corporation. The stock must have been acquired directly from the corporation or its underwriter at its original issuance, held for more than 5 years, and sold before a specified date. Gain of up to the lesser of ten times the amount paid for the stock or $10,000,000 qualifies. Also, the gain on QSBS can be deferred, given certain conditions, by purchasing other QSBS within 60 days. These tax benefits apply only to regular C-corporations, not to S-corporations or LLC’s electing to be taxed as corporations. Note that the § 1202 definition of a small business corporation is different from the one for § 1361 S-corporations and the one for § 1244 stock. Section 1244 allows the treatment of losses on stock disposition as ordinary rather than capital, but usually is of little help because there is usually little or no cost basis in the stock at the time of such disposition. An experienced S-Corporation tax consultant, such as San Diego CPA Michael Fitzsimmons, can assist in evaluating these tax rules in your particular circumstances.
Potential Law Changes
Three significant tax law changes that may occur in the future:
- The two percentage point "Payroll Tax Holiday" in 2011 & 2012, whereby the employee Social Security withholding is 4.2% instead of 6.2%, and the Self-Employment tax at 13.3% instead of 15.3%, is scheduled to disappear at the end of 2012.
- The amount of wages subject to Social Security tax may be increased significantly from $110,100 to several hundred thousand dollars, or all wages may become subject to Social Security tax. If the corporation's profits before owners' salaries are significantly more than $110,100 per owner, this could result in substantial additional tax savings.
- An S-corporation's net income or distributions may become subject to FICA / Self-Employment tax. This would result in much higher taxes, since FICA / Self-Employment tax would be owed on more than just the owners' salaries.
Items of Note
IRS recently allowed several corporations to make the S-corporation tax election after the election period had expired: Private Letter Rulings 201005020, 201005021, & 201005027. Since private letter rulings are not legal precedent under federal tax law, these cannot be relied upon by other taxpayers, but demonstrate that the IRS continues to grant late S-corporation elections. Generally, an S-corporation must make the election no more than 2 months and 15 days after the beginning of the tax year for which it is to take effect. Taxpayer may request a ruling by the IRS by showing that there was reasonable cause for not making the election on time. Recently I successfully petitioned the IRS for a late S-corporation election for a new client and was able to free up more than half a million dollars of losses that would otherwise have been trapped inside of a C-corporation and therefore unusable. Combining this with the business net operating loss (NOL) carryback provisions, the taxpayer was able to offset hundreds of thousands of dollars of other income and obtain more than $100,000 of tax refunds.
Business Tax Strategies
Please refer to these pages for more tax savings ideas:
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