Picking an entity structure for business owners is a crucial decision with legal and tax implications. Would you believe that over 75% of business returns received by the IRS are S-Corporations (“S-Corp”)? Let’s discuss the benefits, limitations, and strategies associated with this structure.
Here are the basics of an S-Corp:
- It’s considered a separate legal entity from the owner.
- Income is passed through to the owners, eliminating double taxation experienced by C corps.
- It can have no more than 100 shareholders with 1 class of stock.
Is an S-Corp a “tax” concept or a “legal” concept?
You don’t create an S-Corp; you ELECT it! The first step is to elect your entity structure (LLC vs Corporation) – this is your legal structure.
The preferred legal entity for small business owners is an LLC due to:
- Fewer corporate formalities.
- Simpler to establish.
- Potentially better creditor protection.
- This is particularly true with multiple owners. An LLC membership interest can’t be used to satisfy a legal judgment.
Key concepts and strategies of an S-Corp:
Wages paid to S-Corp owners are subject to employment taxes, while profits (distributions) are not. Furthermore, profits are potentially eligible for QBI deductions. Because of this, there’s an incentive for owners to keep wages as low as possible. The IRS understands this and requires that S-Corp owners pay themselves reasonable compensation. This is widely interpreted! Here are some things to consider with the reasonable compensation requirement:
- What’s the wage for similar roles in your geographic area?
- How aggressive (or conservative) do you want to be?
The IRS includes health insurance premiums, business HSA contributions, and disability insurance premiums in an S Corp owner’s taxable income. This means they are applied (or included) towards the reasonable compensation concept but are not subject to Social Security and Medicare taxes. Appropriate planning for disability insurance premiums is necessary to ensure that the benefits paid aren’t treated as taxable income.
Qualified Business Income Deduction (QBI)
The Tax Cut & Jobs Act (TCJA) introduced the QBI concept. Its purpose was to keep taxes associated with small businesses on par with the maximum corporate tax of 21% (also introduced by the TCJA).
Although the QBI expires in 2026, many believe it will stick around, considering the 21% corporate tax rate is permanent. The QBI deduction is on the business owner’s personal tax return and equals the lesser of 20% of:
- Combined Qualified Business Income, or
- Taxable Income (before the QBI deduction) less capital gains.
Like most tax deductions, there’s an income phaseout. This makes strategic tax planning paramount! If income exceeds the phaseout, the deduction is further impacted by the type of business (Specified Service or Trade Business (SSTB) or a non-SSTB).
State & Local Tax Limit (SALT)
The TCJA also capped the SALT deduction at $10,000. As a result, more than 30 states introduced SALT workarounds for S-Corps (and partnerships). Here are the mechanics:
- The S-Corp voluntarily pays income tax (referred to as the “Pass-Through Entity Tax”).
- Then, the S-Corp deducts the payment as a “specified income payment.”
- The S-Corp allocates the payment to the shareholders on their K-1.
- The shareholders receive a corresponding benefit on their personal return.
Each state maintains its own stipulations on how to elect this pass-through tax and the corresponding presentation on shareholders’ personal returns.
Here’s a high-level list of other items to consider with an S-Corp election:
- Set up an Accountable Plan to reduce S-Corp income.
- Be mindful of minority ownership (less than 50%); you lose control over distribution timing, which may cause tax timing issues.
- Set up a Family Management LLC to hire family members vs. paying them W2 wages.
Connect with us today if you want to discuss these concepts to see if they’re appropriate for your small business.
Please consult with your financial advisor and/or tax professional to determine the suitability of these strategies. All views, expressions, and opinions in this communication are subject to change. This communication is not an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services.