Business owners often look for tax planning opportunities to reduce their overall tax burden. One highly discussed planning strategy is choice of entity – more specifically a Corporation that elects to be taxed under subchapter S of the Internal Reve Code, an S-Corporation.
To understand the general landscape of entity selection you must first understand there are tax and non-tax considerations relative to each general type of entity. This article assumes you have performed your due diligence on the non-tax items and aims to focus on two key tax concepts surrounding S-corporations. But first –
Generally speaking, Corporations are subject to a double level of taxation – first, an entity level tax on the income of the corporation and second, a tax at the individual level on dividends received by the shareholders.
Partnerships and S-Corporations are considered “pass-through” entities meaning the income of the entity passes through to the partner/shareholder which is taxed on their personal tax returns resulting in a single level of tax. There are no wages paid to owners out of a partnership since all income is subject to self-employment tax at the individual level.
The S-Corporation is a hybrid entity that allows wages to be paid to owners and passes through or distributes earnings to shareholders. Distributions are not subject to self-employment tax.
Finally, a sole proprietor reports income on their personal tax return and pays self-employment tax on all of the income similar to a partner’s income from a partnership.
What does all this mean?
The main advantage that S-Corporations provide from a tax planning standpoint is flow-through taxation similar to a partnership along with the ability receive dividend distributions from your earnings. This unique combination is advantageous over a partnership structure since the dividends are not subject to self-employment tax resulting in smaller tax liabilities.
Before you start talking with your CPA about electing subchapter S status there are two key concepts you should consider; the concept of reasonable compensation and the effect of an S-election on your qualified business income deduction (QBID).
Taxpayers have often attempted to structure S-Corporations’ income and expenses in a manner that allows shareholders to receive payments as distributions, rather than wages, because shareholders of subchapter S corporations are subject to FICA, FUTA and payroll withholding taxes on any wages they earn from the corporation, but not on dividends or other distributions.
Further, in a subchapter S corporation, the question of insufficient compensation may arise when the stockholders are members of a family group and where taxpayers attempt to shift income to family members in lower income tax brackets.
To combat these two tax avoidance strategies, the IRS and courts agree that a shareholder must determine what constitutes reasonable compensation when paying wages and taking distributions from an S-Corporation. To determine reasonable compensation there are several factors to be considered by the shareholder including:
- Number of hours and the quality of the work performed;
- Contribution to the success of the business;
- Compensation of shareholders vs. non-shareholder employees; and
- Salary scale in the industry.
While not all encompassing, these items should give you a reference point to begin your determination of what would constitute reasonable compensation as an S-Corporation shareholder-employee. Further, these factors also play a key role in determining the net Qualified Business Income Deduction enacted under the 2017 Tax Cuts and Jobs Act.
Qualified Business Income Deduction
Probably one of the biggest changes to the Internal Revenue Code under the 2017 Tax Cuts and Jobs Act was the Qualified Business Income Deduction. This introduced a 20% deduction from taxable income for taxpayers other than C corporations with domestic “qualified business income” (QBI) from a partnership, S corporation or sole proprietorship.
In general, the deduction amount for each qualified trade or business is equal to the lesser of (1) 20% of the taxpayer’s QBI with respect to the trade or business, or (2) 50% of the W-2 wages with respect to the trade or business.
For an S-Corporation shareholder the wage limitation for QBI purposes is a very important concept to consider because your overall deduction will be limited by your wages. For example:
T operates a business that generates $800,000 of QBI during 2019 and T pays himself $8,000 of W-2 wages during the year. The W-2 wage limitation is $4,000 ($8,000 W-2 wages x 50%). Thus, T’s QBI deduction is limited to $4,000.
To maximize the tax benefit in this scenario the taxpayer should pay himself a wage of $230,857 to receive the full benefit of the QBI deduction. Per exhibit A-1 below you can see there is a $111,428 increase in the QBI deduction due to the increased wage limitation which resulted in $19,278 in tax savings.
In the case of a partnership, each partner is treated as having W-2 wages for the tax year equal to their income of the partnership. Therefore, typically the QBI deduction is larger than an s-corporation but there is also more self-employment tax paid on earnings. Exhibit A-2 shows that while the deduction is $46,172 greater for the partnership, the overall tax is $4,676 higher for the partner than for the s-corporation shareholder due to the self-employment tax.
Performing your choice of entity due diligence has a significant impact on the amount of money you are keeping in your pockets at the end of the year. There are both quantitative and qualitative factors that come into play but this article shows you the impact of your decision relative to the QBI deduction.
If you need assistance with setting up an entity, tax planning around entity selection, or think converting to a S corporation is the next move for your business, please contact our experts at MKS&H.