Unlocking the Benefits: Top Reasons to have a S Corp
The corporate world is brimming with opportunities and structures designed to optimize operations, minimize tax liabilities, and enhance profitability. Among these, the S Corporation (S Corp) stands out as a compelling choice for many business owners. This entity type, known for its unique tax advantages and operational flexibility, offers a pathway to significant savings and strategic business growth as a legal entity. One of the key requirements for an S Corp is to have a board of directors and corporate officers, which helps with internal practices and formalities such as writing corporate bylaws. Having a board of directors and corporate officers is crucial for maintaining proper governance and ensuring compliance with state corporation laws in the United States.
Choosing an S Corporation structure is not just a tax decision. It’s a strategic move towards a more streamlined and efficient business operation. As companies deal with the complexities of taxes and rules, knowing the benefits of an S Corp can help them save money and follow the rules better. But what exactly is an S Corporation, and why might it be the right choice for you? In this article, we’ll explore the various reasons why an S Corporation structure could benefit your business. It highlights how this choice can help your business grow and stay strong.
What is an S Corporation?
An S Corporation, also known as an S Subchapter, refers to a special tax designation granted by the Internal Revenue Service (IRS) that allows small business corporations to pass corporate income, losses, credits, and deductions through to their shareholders for federal tax purposes. This designation helps avoid double taxation on business income, a common issue with the traditional C Corporation structure. An S Corporation, named after the subchapter “S” of the Internal Revenue Code, combines the legal environment of a corporation with the tax efficiency and operational flexibility of a partnership or sole proprietorship, making it a highly beneficial business structure for small businesses. It is an alternative to the limited liability company (LLC).
Here’s how it works:
Limited Liability
Like a traditional corporation, an S Corp provides its owners (shareholders) with limited liability protection. This means that the personal assets of shareholders are typically protected from business debts and liabilities.
Pass-Through Taxation
An S Corporation doesn’t pay federal income tax at the corporate level like a regular C Corporation does. Instead, it passes its profits and losses through to the shareholders’ personal tax returns, using tax forms such as Form 1120-S. Shareholders are then taxed at their individual income tax rates, which allows them to offset corporate losses with income from other sources. This setup avoids double taxation, which happens with C Corporations. In a C Corporation, the corporation is taxed on its profits, including any passive income, and then shareholders are taxed again on any dividends they receive. This pass-through taxation structure, a key benefit of having an S Corporation status, allows for more favorable tax treatment for shareholders.
Ownership Restrictions
There are certain restrictions on who can be shareholders in an S Corp. For example, an S Corporation is restricted to a maximum of 100 shareholders, all of whom must be either U.S. citizens or residents.
Structural Requirements
In order to elect S Corp status, the business must first establish itself as a regular C Corp or be eligible to do so. Then, the shareholders must file Form 2553 with the IRS to elect S Corp status.
S Corporations are popular among small to medium-sized businesses. They offer liability protection to a corporation while avoiding double taxation. They do have some limitations and requirements that must be met to maintain their status.
The Advantages of Choosing an S Corporation
Selecting an S Corporation as the business entity of choice offers numerous benefits to small business owners. One of the primary advantages is the avoidance of double taxation, a common predicament faced by traditional C Corporations. In a C Corporation, the corporation pays taxes on its profits at the corporate level, and shareholders pay taxes again on any dividends they receive.
However, by registering as an LLC and electing S Corp status, small business owners can save on personal income tax, as they can characterize their income as salary or dividends. This can result in lower liability for self-employment tax, making it a popular choice among LLC owners and small business owners in general. Additionally, LLC owners can also enjoy the tax benefits of the Tax Cuts and Jobs Act, similar to S Corp owners, making it a favorable choice for business structure.
Conversely, S Corporations allow profits (and losses) to pass directly to shareholders, who then report the income on their personal tax returns. This structure not only simplifies the tax filing process but also provides a more favorable tax treatment for business earnings.
Top Reasons to have a S Corporation Structure
Here are some top reasons why individuals might choose to structure their business as an S Corporation:
Reducing Owner’s Salary: A Strategic Approach
One of the most effective methods to slash personal payroll taxes revolves around strategically reducing your salary as an S Corp owner. By lowering your inflated earnings, you can allocate a portion of your income as distributions, which are exempt from self-employment taxes. However, it’s crucial to maintain a “reasonable compensation” level to avoid triggering an IRS audit. This strategy may also be applicable for limited partnerships or limited liability partnerships, depending on the industry and specific circumstances.
To determine this sweet spot, meticulously document your responsibilities within the corporation and allocate appropriate hourly wages for each role you undertake, be it administrative, managerial, or operational. Substantiate your analysis through comprehensive corporate minutes, fortifying your position should the IRS inquire about your justified salary. By adopting this strategic approach, you can significantly minimize your personal payroll taxes while ensuring compliance with IRS regulations.
Covering Owner’s Health Insurance Premiums
As an S corporation owner, you can deduct health insurance premiums for yourself and your immediate family by following specific IRS guidelines. Establish a health insurance plan through your corporation, either by direct premium payments or reimbursements to you. Make sure to include these premiums as wages on your W-2 form so that you can claim the self-employed health insurance deduction on your personal tax return.
However, this deduction is contingent upon you and your spouse being ineligible for employer-sponsored health coverage. Additionally, the premiums cannot exceed your S corp salary to qualify for the deduction. By leveraging this benefit, you can not only provide health insurance coverage for yourself and your family but also enjoy tax deductions that can significantly reduce your overall tax liability.
Employing Your Children: A Dual-Benefit Strategy
Hiring your children within your S Corp can yield dual advantages. While you must pay payroll taxes on their wages, you can shift income from your higher tax bracket to their lower bracket, potentially saving on overall taxes. Moreover, you can contribute to their future financial security by funneling their earnings into retirement or education savings accounts.
Each child can earn up to $12,200 (in 2019) without incurring federal income taxes, providing an excellent opportunity to build their nest egg tax-free. Ensure you document their legitimate work responsibilities to substantiate their wages and avoid potential deduction denials during an audit.
By employing your children, you not only provide them with valuable work experience but also enjoy tax savings and the opportunity to secure their financial future.
Selling Your Home to Your S Corp
If you’re thinking about turning your main home into a rental, here’s a smart idea: sell it to your S corp first. This move helps you dodge taxes on the sale using the home-sale exclusion, which can be up to $500,000 for married couples. Plus, it boosts the property’s depreciable basis, setting you up for bigger tax deductions later.
Here’s how it works: Let’s say you sell your home to your S corp for $750,000, but your basis (what you paid for it) is $250,000. You can use the $500,000 home-sale exclusion to skip taxes on the $500,000 gain. At the same time, your property’s new depreciable basis becomes $750,000. This means you can claim more substantial depreciation deductions on your taxes later.
This strategy helps you save on taxes while still owning your property and earning rental income through your S corp. It’s a win-win for your finances.
Deducting Home Office Expenses
As the owner of an S corporation, you can save money by deducting some of your living expenses through a reimbursement for home office costs. Here’s how it works: Follow the IRS rules in Regulation Section 1.62-2(c). You need to submit reports listing your home office expenses, get reimbursed through your corporation’s accountable plan, and see this reimbursement as a non-taxable employee business expense.
To qualify for this deduction, your home office must be where you mainly work and earn income. You have to prove that you use your home office exclusively and regularly for business purposes. Keep detailed records to back this up, especially in case of an audit. By deducting these home office expenses, you can lower your taxable income, saving money on both personal and business taxes.
Renting Your Home to Your S Corp
If you’re not inclined to convert your home into a rental property, you can still leverage a tax-saving strategy by renting it to your S Corp for up to 14 days per year. The corporation can deduct the full rental amount, allowing you to accrue the income completely tax-free. However, exercise caution and refrain from renting your home for entertainment purposes, as the entertainment facility rule disallows such deductions. Instead, validate the rental by hosting business meetings, staff retreats, or board meetings, ensuring you document the ordinary and necessary business activities with photographs and date stamps.
Renting your home to your S Corp provides a win-win situation. Not only do you generate tax-free income, but your corporation can also deduct the rental expenses, reducing its taxable income. However, it’s crucial to ensure that the rental agreement is properly structured and documented. Consult with a tax professional like Akron Income Tax Co to ensure compliance with all tax laws and regulations.
Using an Accountable Plan for Travel Expenses
As an S Corp owner, you can reimburse yourself for business-related travel expenses through an accountable plan. You can get tax-free reimbursements for expenses such as airfare, car rentals, lodging, meals, and incidentals by submitting comprehensive expense reports that substantiate the business purpose of your travels. This helps you lower your taxable income while ensuring proper accounting for your business-related expenses.
It’s important to note that if you’re a more than 10% owner, you cannot use the per-diem allowance method for lodging reimbursements; instead, you must claim actual expenses incurred. Keep thorough records of your travel expenses, including receipts and itineraries, to support the tax-free reimbursements. By taking advantage of an accountable plan, you can enjoy the benefits of tax-free travel reimbursements while staying compliant with IRS regulations.
Reimbursing Cell Phone Expenses
The IRS acknowledges the importance of smartphones for business needs, allowing S corporations to reimburse their employees for cell phone expenses without incurring taxes. To benefit from this, you can submit your monthly cell phone bills through your company’s accountable plan. It’s crucial to ensure that the reimbursement reflects reasonable coverage costs and isn’t a substitute for regular wages.
In order to remain compliant, it’s important to distinguish between personal and business use of your cell phone. Keep thorough records of business-related calls and activities, and if feasible, maintain a separate business line. By reimbursing cell phone expenses through your S Corp, you can save on taxes while staying connected and productive in your business pursuits.
Leveraging Section 179 and Bonus Depreciation for Vehicles
If you’re buying a big vehicle (weighing over 6,000 pounds) for your business, you can get some great tax breaks. Section 179 lets you write off up to $510,000 (in 2019) of the cost if it’s for business use. For SUVs between 6,001 and 14,000 pounds, there’s a $25,000 limit. Also, new big vehicles might qualify for a 50% bonus depreciation on what’s left after Section 179. This can really cut down on how much tax you have to pay the year you buy the vehicle.
If your business is structured as an S Corporation, you get even more tax benefits. You can use Section 179 and bonus depreciation to write off a big chunk of the vehicle’s cost, which means you pay less tax. This can be a big help for businesses that rely on vehicles, like delivery or construction companies. So, if you’re thinking about getting a vehicle for your business, being an S Corporation could save you a lot of money in taxes.
Maximizing Retirement Contributions
Contributing to retirement accounts before taxes is a smart way to lower your taxable income. If you’re an S Corp owner and don’t have employees besides your spouse or children, think about setting up a solo 401(k) to maximize your retirement contributions and net income. You can put in up to $56,000 (2019 limit) each year and even make a Backdoor Roth contribution without dealing with pro-rata rules. This can be a valuable strategy for maximizing your retirement savings while also potentially reducing your taxable income through the use of social security benefits. Additionally, this can help increase your net income and overall financial stability in the long run.
If you want to contribute more than the solo 401(k) limit, you could look into a Defined Benefit Pension Plan. It lets you make six-figure contributions and still make Backdoor Roth contributions. Talk to a financial advisor to figure out the best retirement plan for your situation.
Saving as much as you can for retirement is crucial for any business owner. With the retirement benefits of an S Corp, you can plan for your future while cutting down on your taxes. This gives you peace of mind and lets you focus on growing your business, knowing your retirement savings are on track.
Deducting Charitable Donations
While S Corp charitable donations are deducted at the shareholder level on your personal tax return, consider “bunching” your donations over multiple years. Instead of making annual contributions, consolidate two or more years’ worth of donations into a single year. This strategy can potentially elevate your itemized deductions above the standard deduction threshold, yielding tax savings.
As an S corporation owner, you have the opportunity to make charitable donations and receive personal tax benefits. By “bunching” your donations, you can strategically time your contributions to maximize your tax savings. Concentrating your donations within a single tax year can surpass the standard deduction threshold, potentially amplifying your itemized deductions. Consulting a tax advisor is advisable to ensure compliance with IRS regulations and to optimize your charitable contributions effectively.
FAQs
What are the advantages of forming an S Corp?
Forming an S Corp provides limited liability protection to its owners, avoids double taxation by passing profits through to shareholders, allows for tax savings through deductions, offers credibility to the business, and can attract potential investors due to its structure.
How is an S Corp different from other business entities like LLCs and C Corps?
S Corporations, or S Corps, differ from other business entities like LLCs and C Corps in terms of taxation. S Corps have pass-through taxation, meaning profits and losses are passed through to the shareholders’ personal tax returns. This avoids double taxation on both the corporate and individual level.
How does the process of distributing profits work in an S Corp?
In an S Corp, profits are distributed according to the percentage of ownership each shareholder holds. This means that if a shareholder owns 30% of the company, they would receive 30% of the profits. This distribution must be documented accurately to comply with IRS regulations.
When to go from LLC to S-Corp?
Transitioning from an LLC to an S-Corp is usually recommended when your business starts generating a higher income, typically around $70,000 or more of profit. S-Corps offer tax advantages for businesses with higher profits, making it a smart move to switch once you reach that income threshold.
Conclusion
Choosing an S Corporation structure for your business can unlock a myriad of benefits, from tax savings to liability protection. By renting your home to your S Corp, utilizing an accountable plan for travel expenses, reimbursing cell phone expenses, leveraging Section 179 and bonus depreciation for vehicles, and deducting charitable donations, you can take full advantage of the opportunities provided by an S Corp. However, it is crucial to consult with a qualified tax professional to ensure compliance and optimize your tax strategy. So why wait? Unlock the benefits of an S Corporation structure today and set your business on the path to success.
