Can You Reduce Tax by Using an S Corporation?

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Is your business run as a sole proprietorship or as a wholly-owned limited liability company (LLC)? Either way, you are required to pay both income tax and self-employment tax. Changing your business to an S corporation may offer the opportunity to cut your tax bill. 

Do you understand self-employment tax basics?

Currently, the self-employment tax is imposed on 92.35% of business income at a 12.4% rate for Social Security up to $137,700 for 2020. Additionally, tax is at a 2.9% rate for Medicare and it is essential to remember that no maximum tax limit applies to the Medicare tax. However, an additional 0.9% Medicare tax is also imposed on income exceeding $250,000 for married couples and $200,000 in all other cases.

Similarly, if your business operates as a partnership in which you’re a general partner, in addition to the income tax, you also must pay the self-employment tax on your distributive share of the partnership’s generated income. However, by choosing to become an S corporation, you will still be subject to income tax, but your company will no longer have to pay self-employment tax, on your share of the S corporation’s income.

Avoiding the self-employment tax is possible because An S corporation isn’t required to pay tax at the corporate level. Instead, the corporation’s items of gain, loss, deduction and income are filtered through the shareholders. This income doesn’t qualify as self-employment income, which means that by using an S corporation, it may be possible to avoid the self-employment income tax. 

Is your salary reasonable?

The IRS does stipulate that the S corporation pay owners a reasonable compensation for services to the business. The compensation package is considered to be wages that are subject to employment tax. These taxes will be split evenly between the corporation and the employee, which can now be considered equivalent to the self-employment tax. If the salary paid to you by the S corporation is not deemed reasonable compensation for your services, the IRS may decide that part of the S corporation’s distributions to you qualify as wages. This allows the IRS to impose Social Security taxes on the amount it considers payments. 

Unfortunately, there is no simple formula to determine reasonable compensation. Most business owners assume that fair compensation is the amount that outside employers would pay for similar services under comparable circumstances. Be aware, however that there are many factors that should be considered when making this determination. 

Can you convert from a C to an S corp

Converting a C corporation to an S corporation often runs into complications. Occasionally a “built-in gains tax” may apply to appreciated assets held by the C corporation at the time of the conversion. However, there may be ways to minimize the impact. 

When a C corporation converts to S corporation status, the tax law imposes a tax at the highest corporate rate (21%) on the net gains of the business. The regulations are in place to prevent the use of an S election to escape taxes at the corporate level, especially in regards to the appreciation that occurred while the business was a C corporation. This tax is imposed when the built-in gains are coming from the appreciated assets being sold during the five-year period after the S election takes effect. This is often referred to as the “recognition period.” 

Consider all issues

JLK Rosenberger can help with these complicated tax laws. Contact us if you’d like to discuss the factors involved in conducting your business as an S corporation, including the built-in gains tax and how much the company should pay you as compensation. For additional information, call us at 949-860-9902 or click here to contact us. We look forward to speaking with you soon.