Paul Mueller for InnovatioNews writes: As we enter the 2nd
half of 2014, there are several key tax planning issues of importance
for S Corporations and their owners. Since their application will be
unique in each situation, we encourage you to contact us to arrange a
convenient time to discuss your specific situation.
Reasonable Compensation – The owners of an active
business operating as a S Corporation enjoy a distinct tax advantage
over other types of tax entities. Earnings that are not withdrawn as
W-2 compensation escape the additional taxes for Social Security and
Medicare. For that reason, it can be tempting for S Corporation owners
to take a relatively small salary, while increasing their corporate
distributions of earnings.
The IRS is well aware of this “loophole” and is vigilant for
egregious situations. Using the analogy that “pigs get fat; hogs get
slaughtered,” we encourage all S Corporation owners to compensate
themselves reasonably to mitigate the risk of a costly IRS challenge.
Though “reasonable” will be different in each situation, compensation
can be a most useful mechanism for paying income taxes in a fashion to
minimize underpayment penalties.
Health Insurance – Most S Corporation owners are
allowed a special deduction for health insurance on the first page of
their personal income tax returns. This is referred to as the
“self-employed health insurance deduction.” In 2008, the IRS issued
Notice 2008-1 to provide guidance on the accounting for this deduction.
Essentially, the S Corporation needs to pay the health insurance
premiums directly or reimburse the owner if the premiums are paid
personally. These payments are then treated as additional wages to the
owner on their W-2.
If accounted for properly, the end result is a full deduction on the
owner’s personal income tax return, rather than treating them as an
itemized medical deduction on Schedule A, which is subject to the 10%
adjusted gross income exclusion. This is certainly a deduction worth
getting right!
Accounting for Operating Losses – While S
Corporations offer many tax advantages, one potential trap for the
unwary has to do with the ability to deduct operating losses on the
owner’s personal income tax return.
The ability to deduct these losses is limited to the owner’s personal
investment in the S Corporation, oftentimes referred to as “basis. In
this context, basis is the sum of the amount invested for stock or
capital plus amounts personally loaned to the S Corporation by the
owner. This sum is annually increased by flow-through earnings that have
not been withdrawn, and decreased by losses previously claimed.
For most S Corporation owners, particularly service businesses, this
never becomes much of an issue. It can, however, become a challenge for
businesses who experience losses and are leveraged with bank loans or
other forms of third-party debt.
This debt, even if the owner has executed a personal guaranty, does
not provide the owner with “basis” for claiming these losses on their
personal return. Losses that exceed an owner’s basis are suspended and
are not currently deductible. Instead, they are carried forward to
future years when they can be used to offset profits, or become
deductible when the owner increases their basis.
Of particular importance is the need to manage the owner’s payroll in
these situations. There could rarely be a worse scenario for the owner
of a S Corporation than to pay tax on W-2 compensation, when the
offsetting deduction from the S Corporation is being suspended due to
basis limitations.
With enough time for advance planning, a concern over inadequate
basis can be addressed and dealt with so that the owner is able to
utilize these losses to minimize taxes.
