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Should my business make an S Corporation election?

This is a question we hear quite a bit. The key is to understand why you might want to do this, what would it mean, and whether there are there any drawbacks. The answers are numerous and far too many to cover in one post - not to mention the fact that absolutely everyone is different. Making this decision requires a face-to-face meeting, an understanding of your situation and then we can plot the best route forward for YOUR company. One size does not fit all. Having said that, we would like to point out some factors that will come into play

So many times people will come to see us and say that they’re friend or relative told them that they can take what they want out of an S Corp “tax free” and so they’re ready to get on that bandwagon. That’s not exactly how it works. Let’s start with the two (main) types of tax.

  • Income tax - everyone with enough income pays income tax. S Corporations pass through their earnings to their owners just like partnerships, LLCs and sole proprietors and income tax is assessed based on those business profits. S Corporation earnings are not tax-free for this very reason.

  • FICA tax (Medicare/Social Security) - all employees pay 1/2 of the FICA tax bill and the employer pays the other half of the bill. In total, this is 15.3% of wages paid. Self-employed individuals pay “both halves” of the FICA tax on the net income of their company. S Corporations only pay FICA tax on wages. The dividends paid to the owners (profits distributed from the business “leftover” after all other expenses) are not subject to FICA tax and that is where the tax savings can come in.

So what are we waiting for? The answer is never “yes” or “no”, but always “it depends”. So let’s look at the conditions:

  • First and foremost, S Corporation shareholders who perform significant services to the company MUST be paid wages or salary. This is non-negotiable. When you make the election to become an S Corp, you become an employee of your own company. Yes, you are still the owner (or one of them), but you are also an employee.

  • The wages or salary must be “reasonable compensation”. The problem is that the IRS does not define what is reasonable. That is left up to the taxpayer to determine and it needs to truly be reasonable. If a brain surgeon decides that reasonable compensation is $25,000/year, that is never going to pass muster if the IRS ever looks at his earnings.

  • How do you know what is reasonable? I have a few questions/positions I like to pose to my clients:

    • If you were sick for a year and could not work, how much would you have to pay someone to do what you do? Going back to our brain surgeon, no other brain surgeon is ever going to go cover his patient load for $25,000. That is unreasonable. Look at online job postings to see what other companies in your field are paying. Look at industry standards. If you are asked, you will need to show how you arrived at your version of “reasonable compensation”.

    • Do you have employees? If so, you didn’t bring them into the company because you’d like to break even. You brought them in to grow and increase revenue. You are making more profit because of their efforts, not just your own. For instance, if you owned a gym, would you personally see to every client, do the laundry, do all of the cleaning and the bookkeeping? You would work, but you would also have people working for you. The profit of your company would not be solely based on your efforts, but those of your team. It does not make sense that you should pay self-employment tax on their efforts. In this instance, it might make sense to convert to an S Corporation.

    • Are you the only person in your company? If you are a one-person-show, it would be difficult to make the argument that the total profit of your company is NOT attributable to your personal efforts, but it is possible. Think of an embroidery shop or a printing business. One person could set several machines running at the same time and thus the machines are the mechanism that lets one person produce far more than he/she could possibly do alone. The business is more profitable because of the machines, not just because of the personal efforts of the owner. In this case, it might make sense to convert to an S Corporation.

    • If you’re the only person and you can only do one thing at a time, an S Corporation probably isn’t right for you. For instance, a truck driver can only be in one place, driving one truck at a time. If he is working alone with no other employees, it would be difficult to defend a position of a lower salary for himself and FICA-tax-free dividends for some portion of his profit. There is no profit that isn’t personally attributable to him.

    • Keep in mind that even if you feel that you might be able to make an S Corporation election under any of these circumstances, your compensation still must be reasonable. Let’s revisit our our gym owner/manager. A personal trainer (his profession before ownership) might make $35,000/year. A personal trainer manager (as he is now the manager of an enterprise) might make $45,000/year. If his company only makes $25,000/year before his salary (thus taking a salary would make his company lose money), it doesn’t make sense to make an S Corp election simply because he wouldn’t be saving any money.

As you can see, there are several moving parts to this argument. There is also one more issue to throw into the mix: the Tax Cuts and Jobs Act. We don’t have the time or space to go into all of the business changes this tax law ushered in but we can tell you that there is a new business deduction called the Qualified Business Income Deduction or “QBID”. In its simplest form, the QBID can mean up to 20% of business net income might be eligible for a deduction from tax (yes, in the best case scenario, that’s 20% tax-free income - but don’t count on best case). What this means to S Corporations is that if you pay yourself less, your business profit is more. 20% of a bigger pie is a bigger piece of pie that isn’t taxed. For instance:

  • Your company makes $100,000 BEFORE your salary. In a perfect, measurable world, your salary might be worth $60,000.

  • So your company’s net income after your salary is $40,000. The QBID deduction (ignoring all other possible limitations for now) would be 20% x $40,000 = 8,000 that is not only FICA-tax-free but is also income-tax-free. Total taxable income on the owner’s 1040: $60,000 salary + $32,000 S Corp profit ($40,000 income - $8,000 QBID) = $92,000 taxable income.

  • Knowing this, you decide to lower your salary to $30,000. Your S Corporation profit is now $70,000 x 20% = $14,000 QBID deduction. Total taxable income on the owner’s 1040: $30,000 salary + $56,000 S Corp profit ($70,000 income - $14,000 QBID) = $86,000 taxable income, $6,000 less taxable income than our original scenario with a higher owner salary.

You can see that there is incentive to “push down” the owner salary. This is exactly what the IRS is expecting business owners to do and we fully expect more scrutiny to be given to this issue. The best policy is to be reasonable with the salary and be able to support why you chose the number you did.

Clear as mud? Call us. We can sit down and go over it with you and answer all of the questions we possibly can.