An S Corporation is a useful vehicle, and it provides many benefits. There are, however, rules that need to be followed… and some opportunities that you shouldn’t miss.
Get a Bookkeeper
You are running a substantial business, and saving money on accounting is not a wise idea. Recording transactions on Quick Books is a good thing to do, but it’s not enough. You need someone with experience to put together the financial statements needed for your tax return.
I can identify obvious problems, and ask helpful questions, but without a knowledgeable review of your detailed transactions, you could be missing important deductions, or exposing yourself to challenges by the IRS.
Keep Sate Registration Active
Every state has a corporation filing requirement, and many have fees.
California requires a Statement of Information every one or two years, depending on whether you originally registered as a corporation or an LLC. They do suspend companies for failure to file, and it’s annoying and expensive to fix. Check with the Secretary of State website to see whether you are up to date.
Reasonable Salary
The IRS requires that an S Corp pay its shareholders a reasonable salary. An S Corp does not pay tax. Its income passes through to the shareholders’ personal tax returns, but this income is not subject to payroll taxes. While there is no clear definition of a reasonable salary, the intention of the rule is to ensure that everyone pays social security and Medicare taxes on their earned income.
A payroll company is another cost of doing business.
Determining the appropriate salary for you involves some considerations:
- Payroll Taxes
Yes, keeping your salary low reduces your payroll tax, which can be about 15% of salary. If it is too low, though, the IRS may challenge it… and don’t forget that these payments determine your future social security and Medicare benefits.
- Retirement Contribution Limits
An S Corp provides shareholders with opportunities to make substantial contributions to retirement plans, far beyond traditional and ROTH IRAs and the benefits available to regular employees. BUT contributions are limited to 25% of the shareholder’s W-2 salary. This is a potential reason to pay a higher salary.
- Qualified Business Income Deduction
The Qualified Business Income Deduction (QBI) applies to income from S Corporations, but the deduction can be reduced to zero if your income exceeds certain levels. If your income is above the threshold, salaries paid by the corporation can qualify you to claim all or a portion of the QBI deduction that was disallowed. This is another possible reason to pay a higher salary.
Retirement Contributions
There are various tax deferred retirement plans available to S Corp shareholders. The plan must be in the corporation’s name, and contributions are made by the corporation on the shareholder’s behalf. Note that you generally must include qualifying employees in these plans under the same terms.
The most common plan in my experience is the SEP IRA. SEP contributions can be up to 25% of your W-2 salary, with a maximum of $57,000 for 2020. You can create and contribute to a SEP IRA after the end of the year, up to the tax filing deadline, including extensions.
Some S Corp owners can’t pay themselves a salary high enough to get the maximum SEP IRA contribution, but they want to contribute more. In this case, they can establish a 401(k) plan. In addition to the corporation’s contribution to the plan, the shareholder can also have up to $19,500 deducted from their salary as a personal contribution. The combined maximum is still $57,000.
Note – a 401(k) plan must be established by the end of the tax year. You don’t have to make contributions until later, but you must set up the plan.
Some corporations with very high income establish “defined benefit” retirement plans. The complexity and cost of establishing and administering the plan can be high, but the maximum contribution can be as high as $230,000.
Health Insurance
Your health insurance is an expense of the corporation, and is considered officer compensation. It should be added to your W-2, and it is then deducted on your personal tax return.
You can keep your health insurance in your own name, but you should have the company reimburse you. A payment from the corporation bank account to your personal account is a good idea.
Self-Rental and Home Office
If you own a property, you can rent it to the corporation, but you can’t take a loss on your personal return. You can carry the loss forward, though.
The corporation can take a deduction for your home office. You should calculate the portion of your home that you use regularly and exclusively for business and allocate costs – rent, mortgage, insurance, maintenance, taxes, etc. based on the square footage used. Self-rental rules apply.
You should have an agreement with the corporation for an accountable expense reimbursement plan, actually invoice the corporation and pay yourself from the corporation bank account.
Auto Expense
You can treat your car as an asset of the corporation, and deduct depreciation and other actual expenses in proportion to the amount of use that is for the corporation’s business.
Alternatively, you can have an accountable expense agreement with the corporation, and bill it for the costs of business use of your car.
Borrowing From the Corporation
When you take money out of the corporation, it is typically a distribution of earnings. The distribution is not taxable, as long as you have basis. That is, as long as you haven’t already taken out all the earnings and cash you have invested. A distribution in excess of basis is taxable to you as a capital gain.
A common ruse to avoid tax is to treat the distribution as a loan from you to the corporation. Don’t do it. The IRS knows this trick, and it stands out like a sore thumb on your tax return.
Sometimes a legitimate situation arises, and the corporation actually lends you money for a short time. Be sure to repay it within a short period of time, and have a written agreement with payment terms and interest.
Capital Contribution vs Lending to the Corporation
When you put money into the corporation, it is either a capital contribution or a loan. If you are the only shareholder, it doesn’t make much difference, as long as you don’t have losses or distributions in excess of your basis.
A capital contribution creates stock basis, and a loan can create debt basis – but only if there is a written agreement in place, specifying payment terms and interest rates.
If you have stock basis, you can deduct losses and take tax-free cash distributions up to the amount of your basis. Your basis is generally your capital contributions plus undistributed earnings. If you don’t have basis, your losses will be deferred to the future, and cash distributions will be taxed to you as capital gains.
You can have debt basis, which allows you to deduct losses up to the total of your stock basis plus your loan to the corporation. The problem is that when you repay the loan, it is taxable to you as ordinary income if you had to use the debt basis in order to recognize losses.
So I would generally suggest making capital contributions instead of loans, unless you have a lot of basis, don’t have losses, and don’t take excess distributions.
If there are other shareholders, of course, there will be other considerations.
Subsidiary S Corp
If you want to start a new, related business, an S Corp can own another S Corp, but it has to own it 100%. There can’t be other shareholders.
Bruce Critchley Tax 