Pass-Through Deduction: A New Wrinkle in Choosing to Form an S-Corp

Accountants have often recommended that entrepreneurs convert their growing businesses into an S-corporation. This is due to a combination of legal and tax benefits. However, after tax reform and the new Section 199A pass-through deduction, S-corporations may not have the same tax benefits. Here’s what happened.

The Traditional Tax Advantage of S-Corporations

The main tax advantage of an S-corporation over filing as a Schedule C sole proprietor is avoiding Social Security and Medicare taxes. These two self-employment taxes apply to every dollar of Schedule C income. For S-corporations, the two taxes apply to wages but not dividends.

A Schedule C filer with a $100,000 net profit would pay $15,300 in self-employment taxes at the current 15.3% rate. An S-corporation owner who takes some of that income as dividends instead of wages can save $1,530 in taxes for every $10,000 they take as dividends.

The reason an S-corporation owner can’t just take all of their share of the profits as dividends is that reasonable compensation rules require them to take a salary equal to reasonable compensation for the services they provide to the business

New 20% Pass-Through Deduction

Under the Tax Cuts and Jobs Act, pass-through businesses get a new 20% tax deduction. This includes S-corporations, partnerships, and Schedule C filers. Congress created this deduction to close the gap between the personal income tax rates that pass-through business owners pay and the now lower 21% flat rate for C-corporations.

The gist of the new deduction is that pass-through businesses subtract 20% of their profit when calculating their income taxes. If their net profit is $100,000, they get a $20,000 deduction and pay taxes on $80,000.

To be clear, the deduction only applies to income taxes, not self-employment taxes. In the example above, the 15.3% self-employment tax is on the full $100,000 not the $80,000 after the deduction.

Pass-Through Deduction on S-Corporation Profits vs. Owner Wages

The wrinkle for S-corporation owners is that only net business profits are eligible for the new deduction. Wages they take from the S-corporation are not eligible because they are deducted from the net profit.

For example, if your business has a $100,000 profit before you pay yourself and you take a $50,000 salary and $50,000 dividend, you only get a 20% deduction on the $50,000 dividend. That makes your deduction $10,000 instead of the $20,000 a Schedule C filer would receive.

Here’s why that matters.

• Assume you can convert $10,000 to dividends by forming an S-corporation and you’re in the 10% tax bracket. You lose $2,000 of your pass-through deduction and pay $200 in extra income taxes ($10,000 x 20% x 10%) but gain $1,530 in self-employment tax savings. The S-corporation wins by $1,330.
• Now take that same $10,000 in the 37% bracket. You lose a $3,700 income tax deduction and pay $740 in extra income taxes ($10,000 x 20% x 37%). But because your income is so high, your Social Security tax is already maxed out and the S-corporation only saves you the 2.9% Medicare tax for a $290 savings. The S-corporation comes out $450 behind.

In addition, some states charge S-corporations higher income taxes or franchise fees than Schedule C filers. Even when the S-corporation wins on federal taxes, it may still come out behind in state taxes, legal fees, and other expenses.

This is very case-specific and will vary based on your business profits, location, and personal tax situation, so you’ll want to ask an accountant to help you run the numbers.

Still Need Liability Protection? Try an LLC

If you’re looking for legal liability protection, an LLC can be a substitute for an S-corporation. LLCs generally have the same liability protections as S-corporations, although you’ll want to double check the details with a lawyer.

An LLC gives you the option to choose to be taxed as either a Schedule C filer, a C-corporation, or an S-corporation. You can also change your tax election in future years. This gives you the flexibility to estimate your taxes and choose the option that results in the lowest tax bill without worrying about giving up your legal protections.

Need help figuring out if you come out ahead with an S-corporation after tax reform? Schedule a free consultation now by filling out the form below.