I am convinced that the S corp is one of the most powerful long-term tax strategies for entrepreneurs. The tax benefits, audit protection and foundation for other tax deductions are absolutely worth your time and effort to research.
Choose the Proper Payroll Level
The actual year-end deadline that’s important for S corp owners is not setting up the S corp itself, but that of choosing the proper payroll level. Setting up proper payroll throughout the year is an important practice to claim payroll as an owner quarterly throughout the year, one can make some final adjustments before year-end to hit the right amount they should claim as a W-2.
1. Self-Employment Tax
The primary benefit of an S corp is that it allows you to minimize the dreaded self-employment tax. When using an S corp, your ultimate share of pass-through of profit, or the company’s net income, will not be subject to self-employment (SE) tax. (SE tax is a combination of Social Security and Medicare taxes also referred to as FICA.)
However, the IRS requires that the owner take a “reasonable salary” for their share of wages from the company. You will want to talk with your tax advisor about the amount of “draws” you took from the company, how much you left in the business to grow, how many hours you worked in the business, This is a subjective analysis, and needless to say, there are a lot of factors to consider. The amount of taxes at stake is significant.
2. 199A Pass-Through Deduction
This is a deduction just for you, the small-business owner receive a 20 percent deduction off our bottom line. So, simply stated, if your business makes $100,000 in net profit, you get a 20 percent deduction or (in this example) a $20,000 deduction. The result: You only pay income taxes on $80,000. If you are in a 25 percent tax bracket (let’s assume combined federal and state), that means you just saved $5,000. Not too bad.
3. Salary and the 401(k) Contribution
When a business owner is willing and able to put away $15,000 or more, the power of the 401(k) is unsurpassed. In fact, the advent in recent years of the Solo 401(k) for the small-business owner is absolutely amazing. While many S corp owners seek to minimize their W-2 salary for self-employment tax purposes, you must also carefully consider your annual planned 401(k) contributions. In other words, if you cut your salary too low, you won’t be able to contribute the maximum amount to your 401(k). Nevertheless, you’ll still be able to make excellent annual contributions compared to those of an IRA.
4. Declaring Health-Care Premiums on the W-2
As an S corp, it’s required and critical that you report the payment of your health insurance in a specific manner. Your W-2 as a shareholder/employee needs to indicate the amount of health insurance paid by the company in Box 14. If it doesn’t, the IRS can disallow the deduction. This is a huge benefit for small-business owners that cannot be taken advantage of by average Americans. Health insurance is 100 percent deductible for a small-business owner, whether you cover your other employees or not.
5. LLC owners and the S Corp Salary
Most small-business owners and even some tax preparers don’t realize that you can make a retroactive election to have an LLC taxed as an S corp for 2019. However, you can only do this if you already have been operating as an LLC all year long. As I stated earlier, one can’t retroactively set up an S corp. However, an LLC can retroactively “elect” to be an S corp.
Many believe there is a hard-and-fast, 75-day rule at the beginning of the year to make this election for all of 2019. This is not the case. Talk to your CPA to follow the correct procedure to get a retroactive election accepted, and have your payroll allocation completed before year-end.
6. S Corp Tax Abuse
Bottom line, the S corp strategy works when it is used properly and is not abused. If you are making more than $40,000 (net) in your business, could use the asset protection and are ready to build corporate credit or better legitimize your business, an S corp could be a perfect fit for you.
If your CPA is discouraging this strategy or claiming that your payroll needs to be so high that the savings won’t be worth it, the problem isn’t the strategy; the problem may be your CPA’s definition of a reasonable salary. Get a second opinion if you are in this situation. You are the captain of your ship. Take control of your business and your tax return.
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