Terumi Echols for Brilliant Solutions Group writes: S corporations provide some of the most powerful tax savings benefits for both investors and small business owners. According to the statistics by the IRS, S corporations represent the most popular type of a small business corporation. However, in making this election, some extra accounting complexity is introduced that prevents business owners from getting all of their legally entitled savings.
In order to be able to take advantage of all of these tax savings, you should focus on the following tips so that you do not miss out on anything.
1. Salaries Should Be Low, Yet Reasonable
S corporation profits are paid to business owners in two forms: salary or profit. Simply put, an S corp owner would generally receive two different types of checks from the business. One would be the payroll checks that will represent the wages of the employees, and the other would be a portion of the business’s profits.
The most important thing a business owner can do to maximize the profit and minimize the tax burden is to pay the shareholder-employees a low salary. However, it should be reasonable. The reason behind this is that when profit is paid out as wages, it is subjected to Social Security and Medicare taxes. This provides shareholder-employees with social security benefits upon retirement. On the other hand, when the profits are paid out as dividends, they are not subject to Social Security or Medicare taxes.
S corporation profits are paid to business owners in two forms: salary or profit. Simply put, an S corp owner would generally receive two different types of checks from the business. One would be the payroll checks that will represent the wages of the employees, and the other would be a portion of the business’s profits.
The most important thing a business owner can do to maximize the profit and minimize the tax burden is to pay the shareholder-employees a low salary. However, it should be reasonable. The reason behind this is that when profit is paid out as wages, it is subjected to Social Security and Medicare taxes. This provides shareholder-employees with social security benefits upon retirement. On the other hand, when the profits are paid out as dividends, they are not subject to Social Security or Medicare taxes.
2. Minimize Distributions
Whenever a small business opts to have a corporation or a limited liability company (LLC) treated as an S corporation, the IRS sends out a warning instructing that the shareholder-employee wages should not be set too low. If the IRS finds the salary to be set too low, it can re-categorize the distributions (referred to as dividends) as wages. If you recall, wages are subject to Social Security and Medicare taxes; whereas, dividends are not. Because the IRS can re-categorize distributions as wages, it is better that you minimize the distributions in the first place. For instance, if the shareholders can save money with one method versus the other, it should be done so within the S corporation, rather than outside of it.
Whenever a small business opts to have a corporation or a limited liability company (LLC) treated as an S corporation, the IRS sends out a warning instructing that the shareholder-employee wages should not be set too low. If the IRS finds the salary to be set too low, it can re-categorize the distributions (referred to as dividends) as wages. If you recall, wages are subject to Social Security and Medicare taxes; whereas, dividends are not. Because the IRS can re-categorize distributions as wages, it is better that you minimize the distributions in the first place. For instance, if the shareholders can save money with one method versus the other, it should be done so within the S corporation, rather than outside of it.
3. Shift Deductions to S Corporation Tax Return
You should also consider moving tax deductions from shareholder 1040 tax returns to the corporation’s 1120S corporation tax return where legally possible. This shift in deductions may not save the owner income taxes, but it will benefit by reducing the number of distributions made to the share holders. For example, let us suppose that an S Corporation made a profit of $150,000 before it paid the shareholder-employee wages. Meanwhile, an individual shareholder purchased health insurance at a cost of $10,000, saved $5,000 annually for retirement and made annual charitable contributions of $5,000. If these were paid by the corporation rather than the individual, then the shareholder would find himself or herself in the same position economically. However, the S corporation would be paying $130,000 as wages and distributions rather than the original figure of $150,000.
You should also consider moving tax deductions from shareholder 1040 tax returns to the corporation’s 1120S corporation tax return where legally possible. This shift in deductions may not save the owner income taxes, but it will benefit by reducing the number of distributions made to the share holders. For example, let us suppose that an S Corporation made a profit of $150,000 before it paid the shareholder-employee wages. Meanwhile, an individual shareholder purchased health insurance at a cost of $10,000, saved $5,000 annually for retirement and made annual charitable contributions of $5,000. If these were paid by the corporation rather than the individual, then the shareholder would find himself or herself in the same position economically. However, the S corporation would be paying $130,000 as wages and distributions rather than the original figure of $150,000.
Conclusion
The above three tax planning tips can go a long way in helping out S corporations to reduce the taxes they have to pay. The secret to financial success lies in proper planning, and all businesses have to ensure that they plan well in advance to avoid any unpleasant surprises later on.
The above three tax planning tips can go a long way in helping out S corporations to reduce the taxes they have to pay. The secret to financial success lies in proper planning, and all businesses have to ensure that they plan well in advance to avoid any unpleasant surprises later on.
Brilliant Solutions Group is a team of Advanced Certified QuickBooks ProAdvisors.
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