Operating a business as an S corporation may provide many
advantages, including limited liability for owners and no double taxation (at
least at the federal level). Self-employed people may also be able to lower
their exposure to Social Security and Medicare taxes if they structure their
businesses as S corps for federal tax purposes. But not all businesses are
eligible — and with changes under the Tax Cuts and Jobs Act, S corps may not be
as appealing as they once were.
Compare and contrast
The main reason why businesses elect S corp status is to obtain
the limited liability of a corporation and the ability to pass corporate
income, losses, deductions and credits through to shareholders. In other words,
S corps generally avoid double taxation of corporate income — once at the
corporate level and again when it’s distributed to shareholders. Instead, tax
items pass through to the shareholders’ personal returns, and they pay tax at
their individual income tax rates.
But double taxation may be less of a concern today due to the
21% flat income tax rate that now applies to C corporations. Meanwhile, the top
individual income tax rate is 37%. S corp owners may be able to take advantage
of the qualified business income (QBI) deduction, which can be equal to as much
as 20% of QBI.
In order to assess S corp status, you have to run the numbers
with your tax advisor, and factor in state taxes to determine which structure
will be the most beneficial for you and your business.
S corp qualifications
If you decide to go the S corp route, make sure you qualify and
will stay qualified. To be eligible to elect to be an S corp or to convert,
your business must:
- Be a domestic corporation,
- Have only one class of stock,
- Have no more than 100 shareholders, and
- Have only “allowable” shareholders, including
individuals, certain trusts and estates. Shareholders can’t include
partnerships, corporations and nonresident alien shareholders.
In addition, certain businesses are ineligible, such as
financial institutions and insurance companies.
Base compensation on what’s reasonable
Another important consideration when electing S status is
shareholder compensation. One strategy for paying less in Social Security and
Medicare employment taxes is to pay modest salaries to yourself and any other S
corp shareholder-employees. Then, pay out the remaining corporate cash flow
(after you’ve retained enough in the company’s accounts to sustain normal
business operations) as federal-employment-tax-free cash distributions.
However, the IRS is on the lookout for S corps that pay
shareholder-employees unreasonably low salaries to avoid paying employment
taxes and then make distributions that aren’t subject to those taxes.
Paying yourself a modest salary will work if you can prove that your salary is
reasonable based on market levels for similar jobs. Otherwise, you run the risk
of the IRS auditing your business and imposing back employment taxes, interest
and penalties. We can help you decide on a salary and gather proof that it’s
reasonable.
Consider all angles
Contact us if you think being an S corporation might help reduce
your tax bill while still providing liability protection. We can help with the
mechanics of making an election or making a conversion, under applicable state
law, and then handling the post-conversion tax issues.
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