An S Corporation can be a beneficial business entity. But not always. Many accountants advise their small business clients to form S Corps, but there are a lot of variables to take into consideration.
I have discussed S Corps previously in this blog. This time I want to emphasize who does and doesn’t benefit from an S Corp, and to point out how using a 401(k) for your retirement contributions can help make the decision.
Remember, though… Everyone’s situation is different.
Important notice – Starting January 1, 2024 corporations, partnerships and LLCs are required to report information on “Beneficial Owners” to FinCEN (Financial Crimes Enforcement Network). Companies formed before 2024 have until December 31, 2024 to report, BUT new companies formed in 2024 and after are required to report within 30 days of formation. See another entry in this blog, or call me for information.
THE USUAL SELLING POINT FOR AN S CORP
An S Corp is called a ”passthrough entity” because with the exception of some state tax, the corporation itself doesn’t pay tax. Rather, its income is included in the owners’ personal tax returns. This happens in two ways:
- The corporation is required to pay the owner a reasonable W-2 salary, and payroll taxes (mostly Social Security and Medicare) are paid to the IRS and the state
- The corporation’s net profit after deducting salaries is included in the owner’s income, but you don’t pay payroll taxes on it.
If you’re a sole proprietor or LLC, you pay Social Security and Medicare taxes on all of your income. That’s about 15%. With an S Corp, you only pay those taxes on your W-2 salary. For example, if your income after other expenses is $100,000, and you pay yourself a salary of $60,000, you save about $6,000 in payroll taxes (15% of the $40,000 that you didn’t pay as salary)
That’s the usual selling point for an S Corp. Now let’s look into it more closely…
WHO MAY BENEFIT FROM AN S CORP?
Individuals who would otherwise be paid a W-2 salary
- There are businesses in which an individual’s only other choice is a W-2 salary. I see it regularly in the entertainment industry, where actors, directors and writers are members of the guilds, and therefore considered to be employees. They have substantial expenses, such as agent, manager and legal fees that would otherwise not be deductible on their federal taxes. With an S Corp, they can deduct these expenses.
- With an S Corp, you can generally make much larger retirement contributions, unless your employer has an extremely generous 401(K) matching policy.
- Where employers are willing to pay you as an S Corp, the ability to deduct expenses and make higher retirement contributions often overcomes some of the negative factors discussed in this article, even if you otherwise wouldn’t benefit from the S Corp.
Medium income businesses
- There is an income level below which, and above which an S Corp offers little benefit, as discussed below. I’m going make a wild generalization, and say it’s roughly between $100,000 and $250,000, depending on an endless number of variables in your personal situation.
Individuals who choose not to make substantial retirement contributions
- While I recommend that everyone make substantial contributions to retirement plans, the benefit of the tax deduction (assuming you go with a tax deferred plan) is less than it might appear to be.
- Retirement contributions are limited to 25% of your W-2 salary, so the greater your salary, the more you can put away for retirement. But the issues that arise here are 1) The more salary you pay, the more payroll tax you pay, and 2) Your salary and your retirement contribution both reduce your business income, and thereby reduce your Qualified Business Income Deduction (QBI). QBI is a deduction of 20% of your business income.
- The obvious downside of low retirement contributions is a smaller retirement fund to draw on later in life. And lower payroll taxes reduce future Social Security benefits.
Taxpayers in states with SALT workaround programs
- California has a Passthrough Entity Tax, which allows a federal tax deduction of 9.3% of your S Corp California income. Other states have similar programs. This can be a deciding factor in the decision to form an S Corp.
WHO MAY NOT BENEFIT FROM AN S CORP?
Income too high or too low
- If your income is below a certain level, your reasonable salary may be a relatively large portion of your total income, and the difference may not save enough payroll tax to justify the costs, which include additional tax prep and payroll costs, plus possible state taxes and fees.
- If your income is too high, your reasonable salary may be at or near the maximum for calculating Social Security tax, so you wouldn’t get the benefit of a reduction. Also, if your income exceeds the limits for the Qualified Business Income deduction, you may lose all or part of the deduction. You would lose it all if you are in the field of health care, entertainment or consulting.
- But don’t let me discourage you if 1) your alternative to an S Corp is a W-2 salary, and you have significant business expenses, or 2) if the benefit of the California Passthrough Entity Tax (or your state’s equivalent) would make it worthwhile.
Other W-2 income
- I have clients whose businesses are a sideline to a job that pays a substantial W-2 salary. If you are already paying near the maximum social security tax through your regular job, there is little or no payroll tax benefit to having an S Corp.
- Your business gives you the opportunity to contribute more to a retirement plan, but you don’t need an S Corp to do that.
- The California Passthrough Entity Tax (or your state’s equivalent) may be a factor to consider, if it justifies the other costs related to the C Corp.
Very high retirement savers
- For those who make the maximum retirement contribution, the salary you would have to pay yourself to do so could wipe out the payroll tax saving. Remember that company contributions are limited to 25% of salary.
- If you want to maximize your Social Security benefit after retirement, you may not want to save on payroll taxes today.
SSTB with high income
- If you are a specified services trade or business (SSTB) – medical, legal, entertainment, consulting, discussed below – with income above the limits, you won’t get much benefit from an S Corp, unless your only alternative is a W-2 salary, or the California Passthrough Entity Tax (or your state’s equivalent) is significant.
THIS MAY SWING YOUR DECISION
A 401(K) plan can increase the benefit of retirement contributions.
- With a 401(K) plan, you can have a personal contribution withheld from your salary. This is separate from any matching contribution from the company, so it is not limited to 25% of your salary, and it does not reduce your Qualified Business Income deduction.
- Your personal contribution can be up to $22,500 for 2023 ($30,000 if you’re 50 or older)
- The company can make an additional contribution on your behalf, up to an overall total of $66,000 ($73,500 if you’re 50 or older), and that will be limited to 25% of your salary.
- For comparison, if you had a SEP IRA, you would have to pay a salary of $90,000 to make a contribution of $22,500. With a 401(K) it would just be the contribution plus related payroll taxes… and any income tax withholding, which would be more effectively paid as estimated payments rather than withholdings.
So if you are in that medium income category, I’m guessing you won’t be putting away a lot more than $22,500 for retirement. But even if you do, only the additional company contribution increases your payroll taxes and reduces your QBI.
SUMMARY OF POSITIVES AND NEGATIVES FOR S CORPS
Social Security Benefits – A negative
Social Security benefits are calculated on the contributions you make over a 35 year period. If you reduce your contributions, you will reduce your annual benefits later in life. Nobody can predict the future, but how much could this cost you if you live to a ripe old age?
Reasonable Salary – Both a positive and a negative
An S Corp is required to pay the owner a “reasonable” salary, to be sure that owners are not escaping payroll taxes altogether. The IRS doesn’t clarify the meaning of reasonable, so there’s room for interpretation. There is incentive to pay a lower salary in order to reduce payroll taxes, but a higher salary allows you to make a larger deductible contribution to retirement plans.
- The maximum salary for Social Security tax is $160,200 in 2023. The closer your reasonable salary is to that, the less benefit you get from the corporation.
- Company contributions to retirement plans are limited to 25% of the W-2 salary you pay yourself.
This is not an issue for sole proprietors or LLC members. They pay payroll taxes on all of their income, and they can contribute up to about 20% of their total income to retirement plans (plus the 401(k) personal contribution, if applicable).
Qualified Business Income Deduction (QBI) – A negative
This is a deduction of 20% of your business income. It includes income for a sole proprietor, LLC member or an S Corp owner. Salary paid by an S Corp reduces the QBI deduction, and so does a company retirement contribution, so it’s another incentive to pay a lower salary (and thereby a lower retirement contribution) or set up a 401(k) plan.
A complication to the QBI deduction is the specified trade or business (SSTB) rule. SSTBs include businesses such as Law, Performing Arts, Consulting and Health Care. If your 2023 income is greater than $182,100 ($364,200 if married) and you have a SSTB, you can’t claim the Qualified Business Income deduction. If your business is not an SSTB, you may claim all or part of the deduction if your business pays a sufficient salary or has substantial assets.
SALT Workaround – A positive
The California Passthrough Entity Tax (or your state’s equivalent) results in a federal tax deduction of a substantial percentage of your state income. This can swing the decision to form an S Corporation.
I will be happy to discuss your situation.
Bruce Critchley Tax 