Unfortunately, the S corporation's extra accounting complexity sometimes means that small business owners don't get all the savings they're legally entitled to. To make sure that you don't miss out on savings, be sure to apply the following tips:
Tip #1: Set a Reasonable But Low Salary
S corporation profits get paid out to the business owners either in the form of salary or profits. In other words, an S corp owner typically receives two types of checks from the business: payroll checks representing wages and dividend checks representing a share of the business profits.
The most important thing an S corporation can do to minimize the tax burden shouldered by the owners is pay shareholder-employees a low though reasonable salary. Here's why: Paying out profit as wages subjects that money to Social Security taxes and Medicare taxes. In comparison, paying out profits as dividends doesn't subject the money to Social Security and Medicare taxes.
Example: An S corporation that makes, say, $100,000 in profit before paying wages or salary to the owner would pay roughly $15,000 in Social Security and Medicare taxes if all the profit is paid out as wages or salary. If only $50,000 is paid as wages, however, the corporation reduces the Social Security and Medicare tax bill from $15,000 to $7,500.
Tip #2: Minimize Distributions
When a small business makes the election to have a corporation or limited liability company treated as an S corporation--both corporations and LLCs can be treated as S corps--the IRS warns about setting shareholder-employee wages too law. That warning also alerts the business about what happens when the salary does happen to be set too low: The IRS can re-classify distributions, or dividends, paid to shareholders as salaries or wages.
Note: Business owners commonly call the distributions of profit paid out to S corporation shareholders "dividends." However, to be nitpicky, under the corporate tax law rules, dividends typically get paid by regular C corporations rather than by by S corporations. S corporations (and partnerships, too) make "distributions" of the profit. But let's return to the idea about minimizing distributions...
The IRS ability to re-categorize distributions as wages means that, to the extent possible, you may as well minimize distributions of profit to shareholders. In other words, don't distribute money to shareholders simply because you can. For example, if shareholders will save the money (say for working capital purposes or for a new business investment), just save the money inside the S corporation--not outside the corporation.
Example: If a corporation makes a $100,000 profit and pays out half of this money, or $50,000 as wages and the other half or $50,000 as distribution, the IRS may be able to re-categorize some or all of the $50,000 distribution as wages. If the corporation pays a shareholder $30,000 of distributions, the Internal Revenue Service can probably only reclassify the $30,000 as salary or wages.
In the end, by minimizing distributions, the S corporation minimizes the money that can theoretically be reclassified as shareholder-employee wages.
Tip #3: Move Deductions to the S Corporation Tax Return
A final easy tip can often be employed by the small business corporation using the Subchapter S rules. You can sometimes move personal tax deductions from the shareholder's personal tax return to the corporate tax return.
Moving deductions from an individual tax return to the corporation tax return may not save the shareholder-employee and S corporation owner income taxes. Afterall, the deduction represents a deduction on both tax returns. But the benefit of moving a tax deduction to the corporation return is that deduction then naturally reduces the distributions made to shareholders.
Example: Suppose an S corporation makes $100,000 in profits before paying the shareholder-employee wages. Further suppose that the shareholder-employee purchases individual health insurance for his family at an annual cost of $10,000, annually saves $5,000 for retirement and makes $5,000 annual charitable contributions. If these deductions are paid by the corporation rather than by the individual, the shareholder finds himself in the same economic position. But now the S corporation is paying out $80,000 in wages and distributions to the shareholder-employee rather than $100,000.
Owners or members, as they are usually called, of an LLC have the choice to elect how the LLC will be treated for tax purposes. However, this was not always the case. In the past, the Internal Revenue Service (IRS) classified business entities as either partnerships or corporations based on four different factors.
The four factors included: (1) Limited liability; (2) Centralized management; (3) Continuity of life; and (4) Free transferability of interest. A business entity would be taxed as a partnership if it possessed two of the four characteristics. It would likely be taxed as a corporaiton if it possessed three of the four characteristics. This led to a lot of confusion and uncertainty for business owners.
Then in 1997, new IRS regulations became effective which allowed the owners of business entities like LLCs to choose the tax treatment they desired. These regulations were known as the "check-the-box" regulations and are found in Income Tax Regulations 301.7701-1 through 301.7701-3. The form for making the election is IRS Form 8832 and details about the election process are set forth in the instructions to Form 8832.
The change in the law offers different choices to entities such as an LLC. It will allow a business operated as an LLC to enjoy all of the beneficial characteristics of a corporation but still be taxed as partnership or, in the alternative, it provides for an LLC to elect corporation tax status and then make the S corporation election.
In a nutshell, partnership taxation provides for the income and deductions to flow through or "pass through" to the partners who then report and pay income tax on their individual tax returns. This is the basic form of taxation for most LLCs and S corporations. On the other hand, if an entity is classified or determined to be a corporation, income taxes will generally have to be paid by the corporation on income that it earns and then later when that income is paid to the shareholders in the form of dividends, they will have to pay tax at their personal level. This is called the "double tax" of corporations.
The partnership form of taxation is beneficial to most small companies because it eliminates this double taxation. LLCs by default receive partnership taxation. This means if the owners do not make an election by filing Form 8832 to be taxed as something different than a partnership the LLC and its members will automatically be subject to partnership taxation principles. A business which forms a corporation and makes the S election is also subject to the basic partnership taxation principles with a few exceptions. In other words, standard LLCs and S corporations are both treated similarly, with a few exceptions, based upon partnership taxation principles.
According to the accountants and tax advisors I work, a business owner can reduce (not eliminate) the FICA or 15.3% self employment tax by forming a corporation and making the S election. However, this reduction in FICA taxes is not available in most cases to the members of an LLC. So a business person can form an LLC and then make the election to be taxed as a corporation by filing IRS Form 8832 and then make the S election by filing IRS Form 2553. By doing this, the LLC can operate with the less formal structure and rules associated with corporations but also obtain reduced FICA tax treatment for the members.
Since both the S corporation and the LLC provide limited liability protection to the shareholders or members, an LLC which elects tax treatment similar to the S corporation, may be an attractive option to discuss with your accountant or tax advisor. You get limited liability protection, basic partnership taxation, with a few exceptions, the chance to reduce FICA taxes for the members of the LLC and operation of the LLC under less formal rules than with corporations.
Both Stephen Nelson & Robert Montgomery are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.
Stephen Nelson has sinced written about articles on various topics from Finances, Setting Up Company and Tax Deductions. Author, accountant and former tax professor Stephen L. Nelson specializes in provding tax planning and preparation services to S corporations. Nelson is also the author of do-it-yourself guides for. Stephen Nelson's top article generates over 90500 views. to your Favourites.
Robert Montgomery has sinced written about articles on various topics from Limited Liability Company, Home Businesses and tax. Attorney Robert Montgomery offers valuable resources for your LLC . Robert Montgomery's top article generates over 5400 views. to your Favourites.