Is Your S Corporation Adding to Your Bottom-Line Profits?

The major tax benefit to operating your business as an S corporation is the possible savings on self-employment taxes. This article examines the tax savings to see if this form of business is right for you as a single-owner or husband-and-wife-owned business. 

You may not need an S corporation if liability protection is your only concern. You can achieve both liability protection and proprietorship status with a single-member limited liability company (LLC). In community property states, a husband and wife can elect single-member LLC status on their federal tax return and thus file a proprietorship return in either the husband’s or the wife’s name.1  

This article focuses on the self-employment tax savings of the S corporation compared to those of the proprietorship. It also discusses the tax and record-keeping costs of these two forms of business.  

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Taking Cash from the S Corporation   

 the business owner, you take cash from your S corporation in four ways: 

1. W-2 income 

2. Rent paid by the S corporation to you for its use of assets that you own and rent to the S corporation 

3. Corporate reimbursements to you for your employee expenses 

4. Distributions from the earnings and profits of the S corporation
   

The S corporation is a pass-through entity. This means that the income and losses pass through to the shareholders and are taxed on the shareholders’ returns. 

For tax purposes, think of your S corporation as a funnel into which you put income and deductions. At the bottom of the funnel are two spouts: spout one for your salary and spout two for pass-through income. The beauty of this pass-through income is that it is not subject to self-employment or any other payroll taxes. This is what produces the tax savings by operating as an S corporation compared with the proprietorship.

Example. Your proprietorship earns $100,000 for the year. You pay self-employment taxes on the $100,000. You now switch to an S corporation and take a salary of $40,000. The remaining $60,000 passes through to you and is taxed on your personal return where it escapes self-employment taxes putting an additional $8,478 in your pocket. 

That’s the good news, but it’s not the complete story. Your savings may actually be less. 😱

State Income Taxes 

State law may not treat your S corporation in the same manner as federal law does. In California, for example, state law imposes on the S corporation a minimum tax of $800, if that is less than the 1.5 percent S corporation tax. So, in California, the S corporation itself pays state taxes on its income. You, of course, also pay taxes on this income. Thus, operating an S corporation in California produces savings not at the self-employment rate, but at the rate after paying the California taxes. 

The same is true in many states. For example, in states with no personal income tax, the S corporation income might be subject to state taxes. Thus, in Texas, a state with no personal income tax, the state corporation tax applies to S corporations. 

 Planning tip. Consider the state tax in your S corporation net savings. 

Salary Too High 

Consider this: Taxpayer X creates an S corporation which pays him a salary of $160,000 and gives him pass-through income of $150,000. (Thus, his total income is $310,000). Because he is already above the FICA limit with the $160,000 salary, this S corporation saves him Medicare taxes of $4,017 on the pass-through income of $150,000 (2.9% times $150,000 times 0.9235). 

  Now this taxpayer has to consider the state taxes on his S corporation. In this case, the state tax on his S corporation income adds $9,000 to his tax bill. His net result: operating as an S corporation costs this taxpayer $4,983 in additional taxes. He also spent money to organize the corporation, file the separate tax return, and change his letterhead and promotional materials. This was an expensive mistake. It’s a true story. 

Salary Too Low 

When deciding to switch from a proprietorship to an S corporation in an attempt to save on self-employment taxes, you have to decide on a salary that’s less than your net income. Say you are the one sole source of income for the operation. How do you justify a salary lower than what you earn? 

 This is a perplexing problem for everyone. In fact, not so many years ago the Treasury inspector general for tax administration did a study that found many S corporations with no salary at all going to the owner-employee.2 The inspector general recommended that the IRS audit these entities and take that easy money for the government. 

 Although the salary range can be broad, this is certain: You need to take some salary. Further, you must justify the salary. Ideally, you would have documentation of why the salary you are taking is a reasonable salary. 

 The good news when you have a salary is that the IRS has had a most difficult time overturning salaries. The bad news is that for S corporations paying no salary, the IRS has been a consistent winner. 

Planning tip. Make sure you take a salary from your S corporation. 

What Do You Give Up to Have Your S Corporation? 

Some of the rules that apply to the S corporation are different from the rules that apply to a proprietorship. For tax purposes, the S corporation is a separate legal entity in spite of pass-through taxation. 

When you decide whether to be or not to be an S corporation, consider all the effects of the change. For example, with the S corporation, you must consider the following: 

Your solo 401(k) and other defined contribution retirement plan contributions are based on salary. If you take a low salary to save on self-employment taxes, you will have a low contribution base for your 401(k) or other retirement plan contribution. (With the proprietorship, you look at your total income for the contribution limits.) 

Your Section 105 medical reimbursement plan benefits are not available to you or your spouse when you are the S corporation owner. The best you can do as the S corporation owner is to take a self-employed medical deduction for health insurance on page 1 of your Form 1040—and that’s only if the corporation buys the health insurance in its name or reimburses you if the health insurance is in your personal name. (With a proprietorship, you can hire your spouse to obtain the Section 105 medical reimbursement benefits. If single, you can use a C corporation to obtain the Section 105 medical reimbursement plan benefits.) 

The pocket tax money strategy, where the parent hires his or her under-age-18 children, blows up when you operate as an S corporation, because the corporation is a separate legal entity from the parent and that separate entity triggers payroll taxes on the wages your S corporation pays the children. 

If you are thinking about changing your form of business to the S corporation, consider the net after-tax cash in your pocket after all savings and pay outs. The best way to do that is with your tax advisor’s help on a side-by-side comparison that drills down to the after-tax cash benefit or detriment. 

Protect Your Corporate Veil 

Without question, you need to do the paperwork right or your S corporation can be disregarded for both tax and legal purposes. This means paying attention to the corporate minutes, shareholder notices, and corporation filings. You can set this up so that it does not take much time, but you cannot ignore it and you need to get it right. 

Because the S corporation is a separate legal entity from you, it is not a checkbook for your personal activities. To avoid trouble, you should use the corporation only for corporate activities. 

Tax law contains a general rule that you may not pay and deduct the expenses of another. The S corporation is a separate legal entity from you. Thus, you cannot personally pay bills on the S corporation’s behalf and the S corporation cannot pay your individual bills. 

Because you are an employee of your S corporation, you must submit expense reports or other supporting documentation for reimbursement of your travel, entertainment, and vehicle expenses. You might want to consider a corporate credit card to help in this regard. Documentation of the expenses for the S corporation must meet the same high standards that exist for the proprietorship. 

You need to keep the corporate accounting and tax records in good order with a decent audit trail. If you are a sloppy record keeper, the S corporation strategy is probably not for you. 

Owning Stuff and Reimbursing in the Right Way 

Say you are about to buy a vehicle for your business. If you operate your business as an S corporation, who should own this vehicle? 

The answer might surprise you, but it’s very practical. Ownership should belong to the one who can obtain the vehicle at the best price, considering all the costs, including insurance. More than likely, that’s going to be you personally. 

Now, let’s say you own the vehicle and use it for the S corporation business. How is the S corporation going to get the deductions? Answer: The S corporation is going to reimburse you for your business use of this vehicle. The corporation has two basic choices for this reimbursement. 

First, your S corporation could reimburse you at IRS standard mileage rates. This gives the corporation the deduction and you have no taxable income for the reimbursed employee expense. 

Now, even though the expenses were reimbursed to you and the employee reimbursements are not reportable as taxable income, the vehicle for which you were reimbursed is a business vehicle. When you sell this vehicle, you will have a deductible tax loss or a taxable profit. 

In fact, you could collect your mileage reimbursements and report them on IRS Form 2106 of your personal tax return as employee business expense reimbursements. You could then take actual expenses against that reimbursement. We don’t recommend this, as it subjects you to the 2 percent of adjusted gross income floor and the alternative minimum tax. 

Your second choice for reimbursement, and this is probably the most cash-beneficial method for you, is for your S corporation to reimburse you for the actual expenses of gas, oil, insurance, car washes, tune-ups, depreciation, Section 179 expensing, and all other expenses.3 In this case, the corporation takes the deductions on its return and you receive reimbursed employee business expenses, which are not taxable to you and don’t even show up on your tax return. 

Of course, just as with the mileage rates, this vehicle is a business vehicle to the extent of your business use, and that means you experience gain or loss when you sell the vehicle. 

Doing the Extra Home-Office Deduction Paperwork 

You can claim the home-office deduction as an employee of your S corporation, but only if you use the home office for the convenience of your corporation. So, have a good talk with your S corporation to determine if there is a need for a home office. For example, the S corporation might insist that you use the main office only for sales or seeing patients and that you do all your administrative work in an office away from the main office (hint, hint: you can choose the home office). 

Whatever the reason, put it in writing. Make sure it’s signed by both the employee and the corporation. (Yes, yes, we know, you are signing in both places; you are talking to yourself, true—but that is the crazy nature of you operating your business as an S corporation.) 

Also, you will want your S corporation to reimburse your home-office deduction to avoid losing out to the 2 percent of adjusted gross income floor and the alternative minimum tax. 

Assigning Your Income to Your S Corporation Probably Means Your S Corporation Is a Sham 

The general tax rule is that income is taxed to the person or entity who earns it.4 If you get checks in your personal name and then endorse those checks to your corporation, in all probability, neither the IRS nor the courts will recognize your corporation for tax purposes. 

For example, say you work as a 1099 sales agent, but all the commission checks are paid to you in your personal name. In fact, the company for which you work as a 1099 agent does not recognize any of its agents as corporations. Assigning this income to your “corporation” does not make it a corporation. As you might suspect, this is going to be a big problem for you in the event of an IRS audit. 

This also is true of a medical practice where the doctor accepts the payments in his personal name and then assigns those payments to his corporation. The patient was not dealing with the corporation. The patient was dealing with the doctor, and the doctor earning the income will be taxed on it. Again, this creates a big mess for the doctor who does not instruct his patients to deal with his medical corporation. 

The Loss Problem 

When you operate as a proprietorship and incur a net operating loss on your business operations, it’s no problem. That loss is deductible, either against other income that year or in a carryback or carryforward year. 

When you operate as an S corporation, you need to consider some net operating loss fundamentals. First, you need sufficient basis (generally investments in and loans to your S corporation) to deduct the S corporation losses on your personal return. 

If you are having a bad year and need to make a cash infusion into the business, you probably want to make an additional contribution to capital rather than a loan. Should the business fail, you may deduct the additional investment as a capital loss, but the loan lands in the miscellaneous deduction category, where it can be lost to the alternative minimum tax. 

Planning tip. Avoid even thinking about these loss deduction problems with your S corporation—simply focus on making money. 

No Double-Taxation Issue 

Because this article compares the proprietorship to the S corporation, double taxation is not a concern. The double-taxation concern pops up when you compare the C corporation to other entities that you might choose. 

Income Splitting 

Sad to say, the traditional benefits of using the S corporation to split income with your college-age children no longer exist as a result of the 2007 Iraq War Funding law. This law extends the application of the kiddie tax to students under age 24, and that eliminates this benefit for this age group.5 You may still use the S corporation to split income with relatives who are not subject to the kiddie tax, but we’ve found the most common use of this tactic is for getting tax dollars to help pay for college. Thus, we deem the income-splitting tactic too narrow a fit for this article. 

Summary 

Is your S corporation producing the tax savings that you want? If not, consider the limited liability company as your choice of entity. With a single-member LLC, you can get the liability protection and the simplicity of the proprietorship, though in some states you still face extra taxation when the LLC is treated as a corporation for state tax purposes. Should the state taxes be high, you might consider the cost of adequate insurance with a proprietorship to take away the liability reason for a corporation or an LLC. 

Perhaps the one major point to take away from this article is that you need to compare the cash results of how you operate today with how you could operate today. If there are little cash and effort differences in the way you operate, stay as you are. But if you find major differences, make the change, pocket the cash, and save the effort. 

You need to know the basic rules to make your S corporation work properly for tax purposes. Keep this article handy, and review it at least annually to keep yourself on target.