Can an S Corporation Help You Save Tax Dollars?
Careful planning lets you shave dollars off your tax bill.
April 10, 2008
by Mark Washburn, CPA/MST
Tax professionals with high income clients face many hurdles when it comes to helping their clients preserve their wealth. For clients who have the ability to direct or determine how they receive income, the choice of entity is an important consideration. While each entity has advantages and disadvantages, and while each taxpayer's circumstances must be carefully analyzed, the S corporation should be seriously considered, especially for self-employed people, because it can provide tax saving opportunities for certain high income taxpayers.
Taxpayers choosing to classify themselves as S corporations can usually avoid several tax issues associated with other entities like sole proprietorships and C corporations. First, S corporations are flow-through or conduit entities, meaning the net income of your client's business flows through to the shareholders and is taxed at the shareholder level. The net income is taxed on the shareholders' personal tax return. The taxpayer reports this flow-through income and is taxed on it immediately. Keep in mind that due to cash-flow needs, not all the income may be made available to the shareholders. Taxes are paid on the net income in the year earned, but actual distributions may follow some time later. These distributions are received tax-free since taxes have already been paid in prior years. Second, the flow-through net income is not subject to the self-employment tax thereby producing another tax savings for your client. You must be careful when it comes to setting the salaries of S corporation shareholder-owners to avoid arguments about unreasonable compensation by the IRS. Setting salaries low to avoid payroll taxes can attract the attention of the IRS. With flow-through income not subject to these taxes, a natural inclination is to purposely set salaries low and allow as much profit as possible to flow through to the shareholders. As long as salaries are reasonable for the services provided, reclassification of profits as salary likely will not be an issue with the IRS. If salaries are kept low, providing some reasoning in the corporate minutes might provide sufficient justification to appease the IRS. For example, if business downturns are expected then prudent business planning might include lower salaries.
Additionally, the avoidance of dividends by an S corporation will not trigger penalty taxes such as the accumulated earnings tax. The alternative minimum tax (AMT) is also not applied at the entity level in S corporations. Rather, it is indirectly applied as one of the separately stated items reported to individual shareholders.
Another benefit available to shareholders of S corporations is the immediate use of losses to the corporation. New businesses generally are not immediately profitable. These corporate losses, known as net operating losses (NOLs), flow through to the shareholders and can be used to offset other income at the shareholder level. Such losses are subject to at-risk and passive activity loss restrictions but still can provide significant tax reductions when start-up businesses anticipate losses in the short term.
Taxpayers whose marginal tax rate is less than the corporate tax rate normally can benefit by choosing to operate their business as an S corporation. The lower marginal rates available to C corporations make the S election less attractive; however, the pass-through feature of the S corporation net profits allows that income to be subject to only one level of taxation.
Income shifting techniques such as gifting shares of S corporation stock by higher-income family members to lower-income family members can be effective devices to lower total taxes. Attempting to shift income by assigning income is prohibited under S corporation rules. In order for income shifting to properly occur, shares must be transferred from one shareholder to another.
Nontax reasons for choosing S corporation status include limited liability protection afforded to shareholders, the ability of shareholder-owners to participate as employees of the business and increased resources available as a result of combining owners' resources.
As with any choice of entity, S corporations provide advantages and disadvantages depending on the circumstances. There are no crystal balls to gaze into, which will foresee all possibilities associated with a particular business. Careful tax planning is necessary to examine potential pitfalls if S status is elected. Although statistics from the IRS reveal that over 80 percent of all S corporations have less than three shareholders, shareholders must be alert to activities which could terminate S status, whether inadvertently or not.
The choice of S corporation for a business can provide significant tax savings if operated correctly. Shareholder-owners must understand the limited nature of this operational envelope in order to avoid problems with the IRS. Due to the many advantages afforded S corporations, Congress has enacted several provisions that impose significant restrictions on what it takes to qualify as an S corporation. As with any tax planning and advice you give, make sure you are current with any changes in the laws affecting S corporations.
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Mark Washburn, CPA/MST, is a Senior Lecturer in Accounting at The University of Texas at Tyler. He teaches both Individual and Corporation tax courses at the undergraduate level. He is a certified public accountant licensed in Texas and holds a Master of Science in Taxation from the University of Texas at Arlington.