The 12 Tax Days of Christmas
Rather than your true love sending you a partridge in a pear tree, wouldn’t you appreciate some money-saving tax tips? For my year-ending 12 Tax Days of Christmas series, I’ll dig back into the archives of previous topical columns to reiterate understandable, realistic and legitimate tax strategies that you need to implement now in order to have a much smaller tax bill come April 15.
For the first tax day of Christmas, your true love is actually going to send you the benefit of an S corporation (S Corp). For those business owners that have an operated as an S corp, you know the importance of dialing in your salary level before year-end. If you fail to do so, you could be leaving big money on the table and even open up yourself for an audit.
I am convinced that the S corp is one of the most powerful long-term tax strategies for entrepreneurs to build upon. The tax benefits, audit protection and foundation for other tax deductions are absolutely amazing.
Choose the Proper Payroll Level
The actual year-end deadline that’s important for S corp owners is not setting up the S corp itself, but that of choosing the proper payroll level. What the business owner wants to do is peg their personal salary from the S corp that covers their compensation for the entire year. Although it’s an important practice to claim payroll as an owner quarterly throughout the year, one can make some final adjustments before year-end to hit the right amount they should claim as a W-2.
As an aside, note that you can’t set-up a new S corp for 2019 at the end of the year and hope to take advantage of its benefits for the entire year. In other words, you can’t backdate the set-up of an S corp. If you are already missing out on this strategy, make sure you are ready to go for next year (more on that in our second tax day of Christmas).
In sum, there are at least six reasons or issues to consider when processing payroll for yourself, and if you don’t have this sorted before you issue that W-2 in early January, it can be very costly and dangerous from an audit perspective to try and fix. Needless to say, choose wisely.
1. Self-Employment Tax
The primary benefit of an S corp is that it allows you to minimize the dreaded self-employment tax. When using an S corp, your ultimate share of pass-through of profit, or the company’s net income, will not be subject to self-employment (SE) tax. (SE tax is a combination of Social Security and Medicare taxes also referred to as FICA.)
However, the IRS requires that the owner take a "reasonable salary" for their share of wages from the company. This is a subjective analysis, and needless to say, there are a lot of factors to consider. You will want to talk with your tax advisor about the amount of "draws" you took from the company, how much you left in the business to grow, how many hours you worked in the business, the comparable salary of someone you would hire to carry out your role, the goodwill of the company name and a whole host of factors.
The amount of taxes at stake is significant. In 2019, the tax is 15.3 percent on the first $132,900 of net income (this amount is adjusted for inflation annually), then 2.9 percent on everything above that. Moreover, at $200,000 single and $250,000 married filing jointly (adjusted gross income or AGI), the Affordable Care Act (ACA) kicks it up another .9 percent, for a whopping total of 3.8 percent for high-income earners.
So the strategy is essentially to take the lowest reasonable salary possible (as a W-2) and the most possible amount of pass-through income (as a K-1). Over the years, after filing thousands of S corp tax returns and payroll reports, reviewing every possible tax court case on shareholder salaries and personally discussing the issues with current and form IRS agents, we created a diagram I refer to as the "Kohler Payroll Matrix".
Keep in mind, this matrix is just a starting point, an illustration of options, and every taxpayer is different. However, it can be a useful visual guide in determining the proper salary level in your S corp from year to year. It’s important to note that this is also an updated version, based on the passing of the Tax Cuts and Jobs Act effective in 2018.
You will see that I begin the diagram with $50,000 of net income and a 50 percent payroll allocation at that level. As such, when taking the operational costs of maintaining an S corp into account, it typically doesn’t make sense to utilize the S corp unless you’re making a net income of at least $40,000. Most importantly, note that determining the proper payroll for a business owner is not an absolute science, and I have found these boundaries to be sufficiently reasonable in discussions with clients and IRS representatives over the years.
2. 199A Pass-Through Deduction
This is a deduction just for you, the small-business owner. Big corporations (essentially C corps) got a new and permanent 21 percent tax rate, but we the small-business owner receive a 20 percent deduction off our bottom line. So, simply stated, if your business makes $100,000 in net profit, you get a 20 percent deduction or (in this example) a $20,000 deduction. The result: You only pay income taxes on $80,000. If you are in a 25 percent tax bracket (let’s assume combined federal and state), that means you just saved $5,000. Not too bad.
The problem is that it’s not that simple. If a business owner’s “taxable income” is above $157,500 if single, or $315,000 married filing jointly, then their type of business, wages paid and business-property value can reduce and/or eliminate the 199A pass-through deduction. Thus, there are a few key issues you want to be aware of when you do your planning and consider the 199A deduction. I discuss this much more in-depth in my newest book, The Tax and Legal Playbook: Second Edition.
However, it’s important to note the purposes of this article and taking advantage of the 199A deduction -- that wages paid are a big deal. Thankfully, wages are defined as any and all W-2 wages paid by the pass-through business, including any W-2 wages paid by the business to you.
Thus, you may want to increase your salary, as a lower wage could backfire for IRS requirements AND the 199A deduction. Here are three general rules of thumb:
- Essentially, don’t stress or be concerned if your taxable income is less than $207,500 (single) or $315,000 (joint). The math is straightforward because you are below the phase-out range and your salary/wage is irrelevant.
- If you are a professional-service business owner and on the out-of-favor list of businesses, consider any strategy to reduce taxable income and avoid the phase-out range and/or cliff.
- If you are operating as a traditional “in favor” business and your income is over $207,500 (single) or $315,000 (joint), it is critical to analyze the business owner’s wages and any equipment acquisitions before year-end to assess the impact on the 199A deduction.
3. Salary and the 401(k) Contribution
When a business owner is willing and able to put away $15,000 or more, the power of the 401(k) is unsurpassed. In fact, the advent in recent years of the Solo 401(k) for the small-business owner is absolutely amazing. While many S corp owners seek to minimize their W-2 salary for self-employment tax purposes, you must also carefully consider your annual planned 401(k) contributions. In other words, if you cut your salary too low, you won’t be able to contribute the maximum amount to your 401(k).
On the other hand, in order to make a large contribution to the 401(k), you may need to take an unnecessarily high W-2 salary from the S corp. This may not make sense for SE tax planning. (There is a sweet spot and balance to this.) Nevertheless, you’ll still be able to make excellent annual contributions compared to those of an IRA.
In short, as long as the business owner meets the "reasonable wage" level, based on their situation, the payroll amount can be adjusted to find the perfect deduction under the 401(k). Moreover, the beauty of the new Solo 401(k) platform is that you can have both traditional and Roth accounts within the same plan and make contributions to both or either account from one year to the next depending on your taxable income and situation.
In 2019, the deferral limit is $19,000 or 100 percent of your W-2, whichever is less. Thus, if you have at least $21,000 (approximately) of payroll income from the S corp, after FICA withholdings, you can contribute $19,000 to your 401(k) account. If you are 50 or older, you can make an additional $6,000 annual contribution if you increase your payroll.
As mentioned above, another benefit of the 401(k) is the non-elective deferral of 25 percent of the payroll, otherwise referred to as the company match. Combined with the payroll deferral, in the example above, the total contribution in 2019 on approximately $21,000 of payroll would be $24,000 ($19,000 plus $5,000 and add another $6,000 if age 50 or over). In fact, depending on the payroll level, the total contribution with matching can now be as high as $56,000. Remember, if you make Roth contributions, you don’t get a tax deduction because you pay the tax on the deferral amount as it’s contributed. However, the company match will be deductible.
Now, here is the rub: Don’t get fixated on contributing the maximum amount of $56,000. Based on the contribution equations, in order to contribute the maximum of $56,000, you need a W-2 salary from the S corp of $148,000. Also, keep in mind that if you have employees other than yourself or your spouse, you are required to implement an approved “matching” program of some sort.
You can also self-direct a 401(k). The plan has its own bank account and is allowed to invest in all the same types of investments as a self-directed IRA and under the same prohibited transaction rules. For more information on the 401(k) set-up that can be self-directed, visit here.
In sum, make sure the 401(k) discussion is on the table when determining your salary, and balance the desire to save on SE tax with the amount you want to deduct and contribute to your 401(k).
4. Declaring Health-Care Premiums on the W-2
As an S corp, it’s required and critical that you report the payment of your health insurance in a specific manner. Your W-2 as a shareholder/employee needs to indicate the amount of health insurance paid by the company in Box 14. If it doesn't, the IRS can disallow the deduction. This is a huge benefit for small-business owners that cannot be taken advantage of by average Americans. Health insurance is 100 percent deductible for a small-business owner, whether you cover your other employees or not.
5. LLC owners and the S Corp Salary
Most small-business owners and even some tax preparers don’t realize that you can make a retroactive election to have an LLC taxed as an S corp for 2019. However, you can only do this if you already have been operating as an LLC all year long. As I stated earlier, one can’t retroactively set up an S corp. However, an LLC can retroactively "elect" to be an S corp.
Your CPA or tax advisor can help you with the procedure and make reference to the proper revenue procedures to include with your Form 2553. Many believe there is a hard-and-fast, 75-day rule at the beginning of the year to make this election for all of 2019. This is not the case. Talk to your CPA to follow the correct procedure to get a retroactive election accepted, and have your payroll allocation completed before year-end.
6. S Corp Tax Abuse
Bottom line, the S corp strategy works when it is used properly and is not abused. If you are making more than $40,000 (net) in your business, could use the asset protection and are ready to build corporate credit or better legitimize your business, an S corp could be a perfect fit for you.
If your CPA is discouraging this strategy or claiming that your payroll needs to be so high that the savings won’t be worth it, the problem isn’t the strategy; the problem may be your CPA’s definition of a reasonable salary. Get a second opinion if you are in this situation. You are the captain of your ship. Take control of your business and your tax return.
Mark J. Kohler is a CPA, attorney, radio-show host and author of the new book, The Tax and Legal Playbook: Game-Changing Solutions for Your Small Business Questions and What Your CPA Isn’t Telling You: Life-Changing Tax Strategies. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. For more information, visit www.markjkohler.com.