Out of the many benefits of an S Corporation, there are two that stand out most. First is the fact that owners and shareholders are not personally liable for corporate losses or debts. Second, there is no self-employment tax on your share of the corporation’s income in excess of your salary. This benefit has been taken advantage of by small business owners for significant savings over the years.
Self-employment tax is the combination of taxes for Social Security and Medicare, also called FICA. In some cases, business owners have abused this tax strategy leading to scrutiny by legislators. In return, some accountants or tax planners have advised against the S Corp. However, acting inside the law, there is no reason for this sort of thinking. Saving self-employment taxes with S Corps is a common and often strong route to go for a small business.
Protecting Your Assets
One of the largest benefits of the S corp is that business owners are not personally liable for debts or liabilities of the business. This is the same sort of protection as received by a C Corp when working within the law. Under what is known as ‘corporate veil’, creditors can only come after assets that lie within the confines of the entity, and not the shareholders.
However, this corporate veil is not impenetrable. In certain cases with an S Corp, corporate veil can be breached. Although the cases differ from state to state, these are the most common situations in which a creditor can come after your personal assets:
When separate corporate records weren’t maintained from your personal records
Deficient capitalization when forming the company
The company was either misused or not used in documents or operations
In addition to these four, there are more situations that may apply. In a court of law, they are balancing your corporate and private activities and assets to determine if you truly had everything separated. The best policy is to show that both corporate and private assets are completely detached.
For more information about S Corporations and the nuances regarding them, visit our Consulting Services.
Self-Employment Tax Savings
When operating as an LLC or sole-proprietor you are subjected to the FICA tax (or self-employment tax). In 2017 that tax is 15.3% of your net income of up to $118,500 and then 2.9% on all income thereafter. As an S Corp, you are allowed to carefully step around this tax for a significant savings.
Owners in the S Corp take payroll through W-2. Then, under K-1, are allowed to take the remaining portion of the company profits as distributions, avoiding the FICA taxes on this portion. The business owner will only pay FICA tax on their payroll income and not the flow-through income from company profits, resulting in paying much lower in taxes.
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Tax Abuse in the S Corp
The tax system of the S Corp has been abused by small business owners quite often. This is usually done by an owner taking little to no payroll, paying little to nothing in self-employment tax. In response to these unlawful actions, legislators in congress have considered limiting this tax strategy, but so far to no avail. Advocacy groups such as the American Institute of CPAs continue to fight and lobby against congress’ actions to limit the tax strategy. The senate has also continued to shut down congress on the topic as well.
So what is the right amount for a small business owner of an S Corp to take as salary wages? It’s not an exact science and it will differ for every tax payer. It is recommended that you speak with your CPA to determine the appropriate salary to distribution allocation for you and your S-Corp. For more help on this confusing area of taxes see our tax services.
Looking Toward the Future for S Corps
More entrepreneurs are choosing to form S Corps than ever before. In fact, 54% of private companies are pass-through companies, either LLCs, partnerships or S Corps. According to the S Corporation Association of America, pass through entities contribute more to the economy than even C Corporations. The S Corp is not going anywhere in America, and the tax laws are not likely to change.
Play it safe, but smart as a business owner when deciding how much your payroll should be. If your accountant is trying to keep your payroll too high and telling you the benefits aren’t worth the risk, question him and get a second opinion. There have been hundreds of IRS cases with business owners receiving little to nothing in payroll, but you need not be discouraged and playing it too safe could mean paying far too much in FICA taxes.
In addition, make sure you don’t blindly jump into making an S-Corp election, as there are several instances in which making such an election is either not allowable, or ill advised given your company’s long term outlook (i.e. plans to seek venture capital down the road). Make sure you have a thorough discussion with your CPA to weigh all the benefits and downsides to the S-Corp election, as a careful analysis should be done prior to any decisions being made.
For more information on FICA or S Corporation taxes visit our Tax Services.
Written by Curt Mastio CPA of Founder’s CPA
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