If you have a business and haven’t done so already, consider whether electing to file as an S-corp is a right move for you. There are some potentially powerful tax advantages that you could gain by electing this tax status.
In this post, we’ll explain what an S-corp is and some of the benefits you could receive by making the S-corp election.
What is an S-Corp?
An S-corporation is not a completely distinct form of business organization, rather an existing business that has chosen a specific tax treatment. That’s why the act of becoming an S-corp is called making an election.
To make the S-corp election, your business must first be a limited liability company or a corporation. The business then elects to be treated as an S-corp for tax purposes.
S-corps are pass-through entities, meaning that just like partnerships and LLCs, the income from the business passes through the business without being taxed first. The business profit is taxed only to the owners at the individual income tax level.
The basic requirements to make the S-corp election are:
- The company must be a domestic corporation.
- Have no more than 100 shareholders. (And only one class of stock)
- Shareholders can only be individuals, certain trusts, and estates. The corporation cannot have as shareholders: partnerships, other corporations, or nonresident aliens.
Here are a few of the ways that making the S-corp election can help you save on your tax bill.
Limit Self-Employment Taxes
As the owner of an S-corp, you can choose to receive the profits that your business generates in two ways. The first way is to pay yourself a salary. The second is to take what is called a distributive share. You don’t have to choose one or the other, and the ability to combine both provides you with an excellent tax-planning opportunity.
When you pay yourself a salary, you have to pay both the employer and employee portion of FICA (Medicare and Social Security) taxes, or the 15.3% that most people know as “self-employment tax”. For the money that you receive as a distributive share, however, that tax does not apply.
For example, say you have a business profit of $150,000. If you pay yourself a salary of $70,000 and the remaining $80,000 is a distributive share, you will pay a self-employment tax of 15.3% on $70,000, not on the $80,000, effectively saving you $12,240 in taxes.
There are some backstops to this strategy, though.
One, you simply can’t pay yourself a zero salary to avoid self-employment taxes altogether. The IRS mandates that you must pay yourself a “reasonable salary”.
Two, that would not likely be the best strategy, anyway. If you completely eliminate your taxable Social Security wages, then you would eradicate your future Social Security benefits, since that is what they are based on. It may make sense to pay yourself a salary up to the maximum Social Security wage base each year (given that is reasonable based on your work), making the most of your Social Security benefits in the long run.
Avoid Double Taxation
One of the most significant drawbacks of the corporate form of business organization is that business income is taxed twice. Corporations are taxed once at the corporate level, and then the owners are taxed at the individual level once the business profits are distributed as dividends to the shareholders.
The S-corporation avoids this double taxation. As mentioned above, S-corps are pass-through entities, meaning that the first level of corporate taxation is bypassed. When compared to a C-corporation, this is a distinct advantage and has the potential to significantly reduce your tax burden.
Personal Deduction on Health Insurance
An S-corp can provide health insurance to employees as a tax-free benefit, but not for the owners.
As a greater than 2% owner of an S-corp, you must include in your income the amount of any health insurance premiums paid on your behalf by the business. However, you are only required to pay income tax on this amount. It is not subject to FICA or FUTA (unemployment tax) taxes as long as the health insurance plan is available to all employees.
You can, however, take a personal deduction for the total premiums paid for by the business as long as the following is true.
- The business establishes the policy.
- It actually pays the premiums for the owner.
- It includes the amount as wages on the owner’s W-2.
Deduct Business Losses
In the unfortunate event that your S-corp incurs a loss, you may be able to deduct that loss against your other income. If your spouse has an income for example, and you incur a deductible loss from the S-corp, you could deduct that loss against your spouse’s income.
The rules for loss deductibility are complex, so make sure you work with a tax professional if you are in this situation.
A key item to note about deductibility is that you must have a taxable basis remaining in the business—meaning you have contributed or loaned money to the S-corp that has not previously been eliminated by losses.
Is An S-Corp Right for You?
Making the S-corp election could be a great way to save a significant amount of money that would otherwise be lost to taxes. As a business owner, you know that it isn’t always about how much revenue you bring in, but how much of it you keep.
At Blue Rock, we love helping business owners align their company finances with their goals from managing 401k plans, tax-efficient withdrawals in retirement, to staying on top of new legislative changes, and more. If you want to discuss whether an S-corp makes sense for your business, schedule a call, and our team would be happy to help you.