Additional Information and Instructions

The S corporation reasonable compensation calculator suggests possible S corporation salary amounts based on shareholder distributions, shareholder wages, the highest paid nonshareholder’s wages, and the Bureau of Labor Statistics data for the job.

The distributions a shareholder-employee receives matter for a simple reason. The Internal Revenue Service can reclassify distributions as wages if an S corporation pays unreasonably low wages to a shareholder-employee.

The amount the highest non-shareholder-employee earns also matters. In most situations, a shareholder-employee would need to be paid more than a non-shareholder employee.

The calculator also considers the most up-to-date Bureau of Labor Statistics annual wages data for more than 800 occupations. More specifically, if available, the calculator grabs the 10th, 25th, 50th, 75th and 90th percentile annual wage amounts.

Adjusting for Inflation

The data used in this 2025 version of the calculator reflects May 2024 annual wages which means roughly a year or more of inflation has occurred since the data were collected. (The BLS published the data in Spring 2025 which means at least a two percent adjustment is probably appropriate.) However, keep in mind that salary amounts don’t always move up even if there is inflation. (We noticed that many salary amounts didn’t change or slightly decreased between the May 2023 and May 2024.)

Understanding the S Corporation Reasonable Compensation Amounts

The S corporation reasonable compensation calculator estimates three amounts or ranges: an “aggressive”salary, a “pretty safe” range, and a “very safe” salary.

“Aggressive” Salary Amount

The calculator estimates the lowest possible, or “Aggressive,” S corporation reasonable compensation amount by identifying the smallest of the following three amounts: the S coporation distributions and wages the shareholder-employee will receive during the year, the annual wages paid to the highest-paid non-shareholder employee, and the 10th percentile annual wages number available from the Bureau of Labor Statistics. The calculator suggests the smallest of these values is probably as aggressive as one should be.

Example: An S corporation pays its shareholder $15,000 in wages and another $45,000 in distributions. (That totals $60,000.) Say the S corporation employs another non-shareholder employee and pays that person $50,000. Also say that the tenth percentile annual wage for the job equals $70,000. In this case, the calculator looks at those three numbers ($60,000, $50,000 and $70,000) and suggests that probably $50,000 is as low as the S corporation should pay its shareholder.

Note: If the S corporation leaves the highest paid non-shareholder employee salary input blank, the calculator assumes the only employee is the shareholder. In that case, if the S corporation pays its shareholder $15,000 in wages and another $45,000 in distributions (again $60,000 in total) and the tenth percentile annual equal equals $70,000, the calculator looks at those two numbers ($60,000 versus $70,000) and suggests that the S corporation should pay $60,000 in wages. (This would mean the S corporation should pay zero distributions.)

“Pretty Safe” Salary Range

The calculator estimates the “Pretty Safe Salary Rage” as any amount falling between the 25th and 75th percentiles assuming those values are available.

The idea here is that if a shareholder’s compensation sits at a level where one in four people in the same job make more or make less, probably the shareholder-employee’s compensation falls within the range of “reasonable.” Note that if a particular annual earnings percentile is unavailable, the calculator displays “Unknown.”

“Very Safe” Salary Amount

The calculator estimates a “Very Safe Salary” as the greatest of the following values: The highest annual wages value available from the Bureau of Labor Statistics for an occupation or the wages paid to the highest non-shareholder employee.

In other words, if an S corporation pays its shareholder-employee the highest annual wages value reported by the Bureau of Labor Statistics? Or, if even higher, the wages paid the highest paid non-shareholder-employee working for the S corporation? That’s a pretty safe number in terms of the Internal Revenue Service arguing an S corporation should have paid a shareholder-employee an even larger salary amount.

Tips for Using the Calculator

A handful of tips. First, the calculator uses national averages. If an S corporation shareholder-employee works in a locality with salaries vastly different than the national average, that difference may undermine the usefulness of the calculator’s estimates. Employers may want to nudge the calculated value up or down to adjust for this.

Second, some small corporations employ shareholders in “more than one hat” roles where the worker does two or three jobs on a part-time basis. Thus, some situations will require the S corporation to average salaries from multiple positions to get to a reasonable compensation estimate.

A third and related tip: You probably want to experiment with different Bureau of Labor Statistics’ occupations. The list the calculator looks at is long. And your job may fit well into more than one category.

Fourth finally, this note from a tax accountant who reviewed the earliest version of this calculator: If a small business corporation’s profits are very modest, the calculator’s “Pretty Safe Salary Range” may be impractically high. A firm generating, say, $20,000 in profits before paying shareholder-employees their wages may not be able to pay anything close to the 25th percentile. Thus apply common sense. And understand that for very small (and probably for very large) S corporations, you may need to take the calculator’s suggestions with a grain of salt.

Related Resources for S Corporations

If you’re working to really maximize your S corproation’s tax savings, you might be interested in this recent blog post: Advanced S Corporation Tax Planning Secrets.

You’ve maybe already seen this other calculator, but you can estimate the payroll tax savings your S corporation produces using the S Corporation Payroll Tax Savings Calculator.

If you’ve got access to ChatGPT, you may also want to get its rather useful input on the appropriate salary to pay an S corporation shareholder-employee. We’ve got more information about that here: Using ChatGPT to Determine S Corporation Reasonable Compensation for Shareholders.

The post S Corporation Reasonable Compensation Calculator appeared first on Evergreen Small Business.

They  don’t. Or at least not yet. And maybe never.

But if you’re an S corporation owner? And you’re struggling to set a shareholder-employee salary? Because ChatGPT does its work for free, and because it’ll often do an adequate job, I think you and I can use it. Its calculations and conclusions should often result in a reasonable compensation number.

But let me step you through the process I’d suggest.

The Trick is Your Prompt

You may already know this. But you ask an AI (artificial intelligence) model like ChatGPT questions.

You can for example ask a question like, “What is the average salary of a carpenter?” Or, “how much does a preschool teacher earn?”

These questions then prompt the AI. And then it returns your answer.

The trick to getting a usable S corporation reasonable compensation number? Providing a good prompt.

For example, a carpenter working as a small contractor in (say) Mount Vernon, Washington might ask, or prompt, the AI with a question like this:

I work as a carpenter and project manager for a small construction company in Mount Vernon, Washington. I have several years of experience. The firm’s total revenues fall between $500,000 and $1,000,000 a year usually. We do small home remodeling jobs. What would be the range of reasonable salaries for this position as well as common fringe benefits? Please cite your sources.

You want, as the above prompt does, to provide as much detail as you can. Also, ask the AI to provide citations for its sources.

When I asked ChatGPT this question in August of 2024, by the way, it provided the following answer—which seems good enough:

In your role as a carpenter and project manager for a small construction company in Mount Vernon, Washington, several factors influence salary expectations, including the size of the company, your level of experience, and regional economic conditions.

Salary Range

For a position combining carpentry and project management at a small firm, here’s a reasonable salary range:

• Salary Range: $60,000 to $90,000 annually.

Breakdown:

1. Carpenter with Project Management Duties: Given your extensive experience and dual role, your compensation would be on the higher end of the scale for similar positions in the area. In Washington state, the salary range for a carpenter typically falls between $50,000 and $75,000. Adding project management responsibilities increases this range.
2. Regional Factors: Salaries in Washington can be higher compared to other states due to the higher cost of living and strong demand for skilled trades. Mount Vernon, being a smaller city, might have slightly lower wages compared to larger urban centers like Seattle, but the difference isn’t substantial.

Sources:

• Bureau of Labor Statistics (BLS): Data on carpenters and construction managers provides baseline figures, with carpenters earning an average of around $60,000 annually, and project managers potentially earning significantly more, especially with specialized skills.
• Indeed & Glassdoor: These job sites provide salary insights specific to roles in the construction industry, with regional variations factored in.

Common Fringe Benefits

1. Health Insurance: Many companies offer health insurance as a standard benefit. This can vary in terms of coverage and the percentage of costs covered by the employer.
2. Retirement Plans: 401(k) plans are common, sometimes with employer matching contributions.
3. Paid Time Off (PTO): This includes vacation days, sick leave, and personal days. For your level of experience and role, around 10-15 days of PTO annually is typical.
4. Tool Allowance or Reimbursement: Given your role involves carpentry, some firms provide allowances or reimbursement for tools and equipment.
5. Professional Development: Some companies support continuing education or training relevant to your job.
6. Overtime Pay: If you work beyond standard hours, overtime pay is usually applicable, though this can depend on the company’s policy and your specific employment status (exempt or non-exempt).

Sources:

• Society for Human Resource Management (SHRM): Provides benchmarks for typical fringe benefits offered by employers.
• Industry Surveys and Reports: Various reports and surveys on construction industry compensation and benefits offer additional insights.

Additional Considerations

• Negotiation: Given your experience and dual role, you might have room to negotiate a higher salary or additional benefits.
• Company Size: Small companies often have less flexibility in salary but may offer other types of compensation or benefits.

These figures and benefits are approximate and can vary based on specific company policies and regional economic conditions.

Thus, I think a small construction company owner who works in Mount Vernon, Washington and who both manages profits and works on the job site as a carpenter might reasonably pay her or himself $60,000 to $90,000 in 2024.

Note: We don’t to my knowledge serve any construction companies operating out of Mount Vernon, Washington. I picked that location because it’s close to where I grew up.

Two Follow-Up Tips

Two follow-up tips if you want to use ChatGPT to set S corporation reasonable compensation.

First, you and I ought to be doing this every year, right? We can save money with an S corporation. But one of the most important rules is, you must set shareholder-employee compensation to some reasonable amount.

Second, save your prompt and the AI’s response as a document. Store it with your payroll records. This document can become something you reference if the Internal Revenue Service or an equivalent state agency ever questions you.

Other Resources Related to S Corporation Reasonable Compensation

A handful of blog resources here you might find useful. First, we’ve got an S corporation tax savings calculator you can use to determine whether you save money with an S corporation. Use that if you’re still researching this idea of reorganizing your business as an S corporation. And then here’s a full list of our S corporation blog posts.

Second, we’ve got a blog post from a few years ago about how to set a safe reasonable salary for an S corporation shareholder-employee: S Corporation Reasonable Compensation. That’s worth reading for a little more detail on the bookkeeping.

And then the Internal Revenue Service provides a helpful summary here: IRS Fact Sheet on Wages for S Corporation Officers. That should be required reading.

The post Using ChatGPT to Determine S Corporation Reasonable Compensation appeared first on Evergreen Small Business.

Five million small businesses operate as S corporations. And surely most of those folks know the simple trick for saving money with an S corporation. You pay a low salary and avoid payroll taxes.

Too many S corporation owners, unfortunately, do not know about all the other more advanced S corporation tax planning tricks and tactics. Thus, this month’s blog post.

Basic S Corporation Trick: Avoid Payroll Taxes

To start, however, I want to review the standard, simple S corporation trick for saving taxes. Just to make sure we’re all on the same page.

And to do this, let me give a quick example where a business owner earns $100,000. I’m going to slightly round the numbers, by the way. That’ll keep this blog post more readable.

Tip: Use our free calculator to estimate S corporation tax savings for your situation: S Corporation Tax Savings Calculator

If the business operates as a sole proprietorship or a partnership and the owner realizes $100,000 of profit. He or she pays Social Security and Medicare payroll taxes on most of the $100,000. Those taxes run roughly 14%, which means about a $14,000 payroll tax. (The actual formula might work like this: a 15.3% tax on 92.35% of the $100,000. And now you see why I’m rounding numbers. And simplifying.)

If the business instead operates as an S corporation, however, tax law allows the business owner to split the $100,000 into regular employee wages and then a shareholder distributive share. The split, by the way, needs to be fair. The resulting shareholder-employee wages amount needs to be reasonable.

But if a business owner can reasonably split the $100,000 of profit into $50,000 of wages and $50,000 of distributive share, he or she halves the payroll taxes. The savings in this case run slightly more than $7,000 a year, which is great.

Too many S corporation shareholders stop there, however. Because a bunch of other powerful, more advanced S corporation tax planning tactics exist.

Trick #1: Optimize for Section 199A Deduction with Higher Wages

A first powerful technique: some business owners pay too little in W-2 wages by focusing just on the payroll tax savings. But if a business generates Section 199A qualified business income and earns its owners a high income, the owners need wages to support a full Section 199A deduction.

The Section 199A deduction, something we’ve talked about a lot through the years (see list here), allows a taxpayer to avoid paying income taxes on the last twenty percent of her or his taxable income. If a taxpayer’s income rises above a threshold amount—roughly $200,000 for a single filer and roughly $400,000 for a married filer in 2024—the Section 199A deduction can’t exceed more than 50 percent of the W-2 wages paid by the business.

Now to be clear, you can’t arbitrarily set your wages to some amount simply to optimize your 199A deduction. You need to pay yourself a reasonable salary. But in general, if you’re losing 199A deductions because you don’t have enough wages, you want to look at bumping your wages so you’re paying out 2/7ths of your profits as wages and 5/7ths as shareholder distributions.

Example: An S corporation makes $7,000,000 in profit for its owner. The owner pays herself $500,000 in W-2 wages, and those are the only wages. This approach limits her Section 199A to just $250,000. If she can reasonably bump her wages to $2,000,000, she increases her Section 199A deduction from $250,000 to $1,000,000. That bump should save her about $280,000 in income taxes.

Trick #2: Split a Specified Service Trade or Business to Requalify for Section 199A

Another 199A gambit: many high-income S corporations lose the Section 199A deduction because some part of the operation is a specified service trade or business (SSTB). These SSTBs include most of the traditional professions (but not all), performing artists, athletes, and celebrities.

But a tip? Many entrepreneurs operate multiple trades or businesses, some of which are SSTBs, and some of which are not. Often, the entrepreneurs hold these businesses in a single S corporation entity. The problem here: combining an SSTB and a non-SSTB disqualifies the entire business for purposes of Section 199A. This leads to an obvious idea: if the business owner can split one S corporation into two S corporations, that’ll often re-qualify some of the income for the Section 199A deduction.

Example: A physician owns a clinic and earns $400,000 practicing medicine. He also provides continuing medical education services in his specialty and earns $400,000 from that. If he combines those two activities in a single S corporation, he loses the 199A deduction on 100% of the $800,000 of income in all likelihood. Practicing medicine counts as an SSTB. And if half the taxpayer’s activity is SSTB-related, that taints everything. If, however, he separates the two activities into separate trades or businesses, probably using a couple of S corporations, he can get a big $80,000 199A deduction on the second non-SSTB business of providing continuing medical education. The savings here: close to $30,000 annually.

Trick #3: Elect to Pay Pass-through-entity Tax

A quick option for shareholders living in states with income taxes.

You can probably pay the state income taxes you individually owe on your S corporation profits directly from the S corporation. To do this, you make an election to pay a pass-through entity tax. And you want to do this.

Here’s why: if you personally pay the $30,000 in state income taxes on your S corporation profits, you almost surely don’t get a federal tax deduction for the payment. (Federal tax law limits the Schedule A tax deductions for state and local taxes to $10,000.) However, if your S corporation pays the $30,000 as a pass-through-entity tax, you almost surely will get a $30,000 federal tax deduction. If your federal tax rate is, say, 24%, that tweak to your tax accounting should save you about $7,200.

Trick #4: Use Tax-free Fringe Benefits

A simple gambit: you want to load as many tax-free fringe benefits onto your S corporation tax return as you can. These fringe benefits bump your shareholder-employee compensation without bumping your payroll taxes.

Example: Suppose an entrepreneur owns an S corporation that generates $100,000 of profit but wants to pay herself $50,000. That amount might be unreasonably low. But if she provides herself with $30,000 of health insurance (which counts as wages but isn’t subject to income or payroll taxes), that $80,000 of W-2 wages and fringe benefits might rise to the level of reasonable.

Trick #5: Set up a Generous Pension for Shareholder-employees

We think most small businesses want to set up good employee pension plans for rank-and-file employees. That step, especially when small firms compete for talent, makes good sense as a business practice in many situations.

But entrepreneurs also want to think about pensions as tax planning gambits they can use to not only save taxes but build wealth outside of their equity in the business.

Example: A Simplified Employee Pension (SEP) plan lets a business owner contribute up to 25 percent of their W-2 wages. Someone who pays herself $50,000 in base wages and then $30,000 in health insurance might be able to pay a $20,000 SEP contribution. This pension plan contribution in this situation probably saves payroll taxes. (With an S corporation, the SEP contribution saves both income taxes and payroll taxes.) And it also probably increases the reasonable compensation. Someone who receives $50,000 in base W-2 wages, $30,000 in health insurance benefits, and $20,000 of pension contributions arguably enjoys a $100,000 compensation package.

But higher-contribution options exist too. Inexpensive 401(k) plans in many cases not only allow for 25 percent employer contributions but let the shareholder-employee also add elective deferrals (from their W-2 wages) that in 2024 equal $23,000 for most individuals and $30,000 for folks aged 50 or older.

In special cases, an S corporation allows a shareholder-employee to set up a defined benefit plan that might allow an even larger employer contribution. Perhaps a low to mid six-figures deduction in some situations? Again, in this case, that pension benefit should count toward the reasonable compensation requirement. And as with SEP contributions and employer matching for 401(k) plans, a large defined benefit plan contribution saves not only income taxes but payroll taxes.

Trick #6: Own Partnership Interests Through an S Corporation

A partnership cannot own an interest in an S corporation. In essence, only U.S. citizens and permanent residents, and other taxpayers very similar to U.S. citizens and permanent residents can own interests in an S corporation. But this rule gets twisted and scrambled sometimes.

For example, the rule about eligible shareholders sometimes gets rephrased (incorrectly) as saying that an S corporation cannot own an interest in a partnership. But it can. Thus, if you own partnership interests in working trades or businesses and those partnerships generate self-employment income for you, you should explore with your tax advisor the possibility of setting up an S corporation and then having your S corporation own your partnership interests. That tiered structure—owning an S corporation that owns a partnership interest—will let you harvest many of the benefits of owning an S corporation already discussed on your partnership income.

A sidebar: Partnerships provide their own tax planning benefits including the ability flexibly allocate income and deductions. Thus, combining partnerships and S corporations in a tiered structure often lets you enjoy the best of both worlds.

Trick #7: Group Compatible Activities with an S Corporation

If you own an S corporation that operates an active trade or business generating strong profits and you start a new business, you need to consider making grouping elections that combine a loss-generating activity with the profitable S corporation’s activity.

Example: If you own two activities, materially participate in the one making $500,000 a year but don’t materially participate in the one losing $300,000 a year, you can’t use the $300,000 in losses to shelter any of the $500,000 of income. However, chances are good that you can find a way to group the two activities into a single activity. And that grouping will let you use your material participation in the one business for both businesses.

Predictably, the IRS requires your grouping to follow common-sense rules. We discuss those in another blog post here: Grouping Activities to Achieve Material Participation. But the general concept? The grouping needs to be timely and reflect common sense.

Trick #8: Use the Self-rental Rules to Harvest Big Real Estate Deductions

A related trick: in theory, real estate investments should allow entrepreneurs to shelter other income. Say someone owns a business that generates $200,000 of taxable income and owns a real estate property that loses $100,000 on paper due to depreciation.

A taxpayer might think he or she can use the $100,000 loss to shelter half of the $200,000 in income. However, in many cases, tax law prevents you from doing this. A specific chunk of the law, Section 469, prevents you from taking the easy obvious deduction in most cases.

A handful of ways exist to dodge the Section 469 limitations on real estate-related losses, however. And one of the most powerful ways works for profitable S corporations. If you elect to group a self-rental property with the other active trade or business using the property, the Section 469 loss limitation rules don’t apply if you set things up right.

This gambit is a little tricky. The ownership percentages of the rental property and the S corporation need to match. Also, you need to make the grouping election when you acquire the property. But done right, you can use depreciation deductions from real estate you own and use in your business to shelter that business’s income.

One other note: normally nonresidential property results in a tiny trickle of real estate depreciation deductions over basically four decades. That doesn’t do much to help with a profitable business you’re running today. You can, however, frontload your depreciation deductions using accelerated depreciation. In some cases, you might be able to immediately deduct ten, twenty, or even thirty percent of the purchase price in the year you invest.

Trick #9: Put a “Hobby” Inside Your S Corporation

Okay, I want to be very careful here. I am not saying you can operate a hobby inside your S corporation and thereby deduct hobby losses or hobby expenses. Again, not saying that…

Furthermore, for you to deduct expenses on a business tax return, you must be engaged in the activity in pursuit of profit. That’s a requirement of a little chunk of tax law called Section 183 and popularly referred to as the “hobby losses rule.”

However, some activities you engage in for profit may look like a “hobby” or an “activity not engaged in for profit” if you operate the activity outside of an S corporation. In a worst-case scenario, you lose the deductions these activities generate. Putting the income and expenses inside your S corporation may work, however.

Example: Say you do barn design and home interiors design that reflect an owner’s interest in and love of horses and all things equine. Maybe you sell your work to horse folk who can’t normally be approached or marketed to using telephone calls, email blasts, or direct mail. But you can effectively market through personal one-on-one selling if you’re riding your own horse at dressage competitions, cross country events, or hunter jumper shows.

In this case, you very likely might lose your deductions if you conduct your horsemanship activities outside your business. But if you do all this stuff “inside” an S corporation that does barn and home design work, the deduction will probably work. (For an example of how this might work, take a peek at this Tax Advisor article: Aggregating Activities to Avoid the Hobby Loss Rules.)

Trick #10: Section 1202 Qualified Small Business Stock Inside an S Corporation

A final trick to mention: some stock in C corporations qualifies as Section 1202 Qualified Small Business Stock. The attraction of this qualification? When the stock is sold, capital gain is either partially or wholly avoided as long as the requirements are met. For stock acquired after Sept 28, 2010, the exclusion equals 100% of the gain if held more than five years. (A handful of other requirements exist too.)

Stock in an S corporation can’t “be” Section 1202 stock. But some taxpayers who own S corporations have a workaround on this. A taxpayer who owns an S corporation with a valuable activity that can be spun off into a separate C corporation can often get Section 1202 for that corporation.

We’ve got a longer discussion of how Section 1202 works here: Section 1202 Qualified Small Business Stock Exclusion. But know for now that you might be able to use the Section 1202 tax planning strategy even for some activity you start up inside an S corporation.

Example: A taxpayer does contract programming as an S corporation. A few years after starting this venture, the S corporation owner working weekends also develops a software program. The S corporation then “incorporates” a new C corporation owned by the S corporation and contributes the software program to that new C corporation. Thus, the S corporation owns a C corporation that owns and sells the software program. Assume at the point the software program is contributed to that new C corporation the software program and therefore the C corporation is worth $1,000,000. Further assume the S corporation sells the C corporation for $11,000,000 five years later. In this situation, the S corporation will treat $10,000,000 of the $11,000,000 of gain as Section 1202 qualified small business stock gain and pay zero income taxes.

A Final Comment about Advanced S Corporation Tax Planning

Your existing tax advisor probably knows about all this stuff. So, if you’ve got questions or ideas you want to run by an expert, talk to her or him. (I mention this because I see too many advertisements on social media sites where someone advertising “tax strategy consulting” suggests they know something your regular tax advisor doesn’t.)

But if you don’t have access to someone expert you can easily ask about these sorts of ideas? Sure. Go ahead and reach out to our CPA firm. Here’s how to contact us: Click here. We’d be happy to discuss working with you.

The post Advanced S Corporation Tax Planning Secrets appeared first on Evergreen Small Business.

In some cases, a small business may still be able to treat their business as an S corporation for the year ending soon. And in most  cases, a small business can begin operating as an S corporation next year.

Reminder: Get the complete list of tax strategy posts here: Tax Strategy Tuesday.

One Person S Corporation Tax Strategy in Nutshell

The best way to showcase the power of the one person S corporation is by comparing the payroll taxes a sole proprietor pays with the payroll taxes a one person S corporation pays.

Let’s use the simple round-number example where a small business earns $100,000.

If this entrepreneur operates as an sole proprietorship, he or she pays not only income taxes but a 15.3 percent self-employment payroll tax on 92.35 percent of the $100,000.

Do the math, in fact, and the formula calculates roughly $14,000 of payroll taxes.

If this business operates an an S corporation, however, and she or he earns $100,000 in profits, the taxes work differently.

In a nutshell, the business owner decides what portion of the $100,000 to call out as wages. And then he or she pays the 15.3% payroll tax on just that portion. (The business owner will pay essentially the same income taxes.)

If a business says, for example, that $40,000 of the $100,000 should be wages—and then does the payroll tax accounting correctly—the business owner pays roughly $6,000 in payroll taxes.

And that’s where the S corporation tax savings show up: $6,000 in payroll taxes instead of $14,000 in payroll taxes.

One key, key issue here won’t surprise you: Tax law requires the business to pay the owner reasonable wages.

Tip: Use our free calculator to estimate S corporation tax savings for your specific situation: S Corporation Tax Savings Calculator.

Tricks that Make One Person S Corporation Tax Strategy Work

Many one person S corporations deliver generous tax savings to their owners by setting the owner wages too low. But you don’t want to do that. Further, knowledgeable, reputable tax accountants never condone that approach. And usually, they refuse to knowingly enable that approach.

But two tricks often allow a business to safely set a very modest salary that saves big amounts.

One trick: Load up the S corporation’s tax return with tax-free fringe benefits for the shareholder-employee. Essentially, these count as compensation but don’t trigger payroll taxes.

Example: James used to operate a sole proprietorship that generated $100,000 in business profits and paid roughly $14,000 in self-employment taxes. He now operates as an S corporation and pays himself $40,000 in wages. That means he pays roughly $6,000 in Social Security and Medicare taxes, thereby saving roughly $8,000 annually in payroll taxes. He and his accountant consider this approach reasonable because of the extremely generous tax-free fringe benefits the S corporation provides: $12,000 of health insurance, an $8,000 health savings account, and a $15,000 employer pension fund contribution.

A second trick: If an S corporation retains earnings for business purposes, the business owner sidesteps paying payroll taxes on that money.

Example: James from the preceding example shows $25,000 of leftover S corporation profit after paying modest wages and generous fringe benefits to him. He pays income taxes on the $25,000 but not payroll taxes due to the S corporation. Probably that’s very safe if he retains that $25,000 as working capital in the business. For example, as cash in the company checking account. Or dollars invested in inventory.

Possible Tax Savings from One Person S Corporation Tax Strategy

Operating a business as an S corporation rather than as a sole proprietorship often saves a one-person business owner many thousand dollars annually. Further, unlike many tax reduction schemes, S corporation tax savings often count as permanent tax savings that roll on for years and years.

Someone who reduces their taxes by, say, $8,000 a year via a $25,000 or $30,000 pension fund contribution probably pays that tax back—or some of it anyway—later on when the taxpayer withdraws the funds.

Example: John reduces his tax bill by $8,000 annually through a pension plan to which he contributes $25,000 each year. Over his working years, he hopes to accumulate $1,000,000 in his retirement account. At that point, though, he’ll begin drawing $40,000 a year. And he’ll probably at that point pay $6,000 or $8,000 in taxes annually.

With an S corporation, in comparison, the taxpayer never pays back the annual payroll tax savings. If the tax payer saves $8,000 a year, for example, she or he gets to keep that money.

Turbocharging the One Person S Corporation Strategy

Higher income one person S corporations need to carefully check the math. But if a taxpayer’s income rises high enough, an S corporation may generate additional savings. Those savings? The Section 199A deduction.

If a taxpayer’s taxable income, for example, equals $500,000, a taxpayer’s business needs W-2 wages in order to qualify for the Section 199A deduction.

Example: Rutherford and Calvin both operate one person businesses that generate $500,000 in taxable profits. Rutherford’s business operates as a sole proprietorship and so pays zero wages. As a result, he receives no Section 199A deduction. Calvin, in comparison, operates as a one person S corporation and pays himself $150,000 in wages and $50,000 in fringe benefits. That leaves $300,000 of leftover S corporation profit. And he gets a $60,000 Section 199A deduction.

Note: The simple version of the Section 199A formula says a taxpayer gets the lesser of 50 percent of the $150,000 of wages or 20 percent of the $300,000 of business profit.

Limits to Tax Strategy

Small business owners have used the one person S corporation gambit for nearly seventy years. And often with great results. But several limits exist to using the strategy.

First, relatively high fixed costs mean the strategy often fails to generate net savings for the smallest small businesses. Especially for part-time or sideline ventures operated by someone who works full-time at a regular W-2 job. Note that extra accounting costs often run $2,000 annually. So, the first couple of thousand dollars a small business saves in payroll taxes go right back out the door to pay for accountants and payroll services.

Second, not every business qualifies to be an S corporation owner. As a simplified rule of thumb, only U.S. individual taxpayers qualify to own shares in an S corporation. (Some wiggle room exists with regard to eligible shareholders so talk with your tax advisor about the detailed rules.)

Third, as incomes rise, the payroll tax rates change: Payroll tax rates start at 15.3 earnings (up to $147,000 in 2022). Ratchet up to 3.8 percent at $200,000 of earnings. And then, between the 15.3 and 3.8 percent tax brackets, a 2.9 percent bracket exists. (That bracket is shrinking every year due to inflation adjustments in the 15.3 percent limit.) And the point here: One person S corporations fairly easily generate payroll tax savings when the taxpayer avoids the 15.3 percent tax rate. But not so much when the taxpayer avoids the 2.9 percent or 3.8 percent tax rate.

How This One Person S Corporation Strategy Can Blow Up

The IRS rarely audits S corporations and so rarely challenges one person S corporation salaries. Ironically, then, small business owners probably don’t need to worry too much about that. (This is not the same thing as saying you can ignore the rules, by the way. Don’t ignore the rules.)

But the one person S corporation strategy easily can “blow up” for other reasons.

For example, some small businesses lack the organizational aptitude to operate the accounting system and the formal payroll system required. (If someone can’t do a regular payroll or run bookkeeping software like QuickBooks, Xero or FreshBooks, that’s a signal the one person S corporation thing may not work well.)

Another factor to consider: A small business needs basically either a corporation or limited liability company to function as the foundation for the S corporation. In effect, the whole S corporation thing is just a bookkeeping approach these types of legal entities use. Accordingly, the one person S corporation needs to be willing to deal with her or his state’s legal red tape.

A caution for existing businesses with debt: When an LLC elects to be treated as an S corporation, that triggers a deemed incorporation of the small business. Usually for a one person S corporation, that deemed incorporation triggers zero income taxes. But if the LLC owes liabilities (such as a vehicle loan), the deemed incorporation can trigger a large tax bill. Taxpayers in this situation should consult their tax advisors.

Finally, this caution: The Build Back Better Act proposes eliminating the S corporation gambit for high income taxpayers. (We’ve got a longer blog post here that explains how that works: Build Back Better Hits High-income S Corporations.)

The One Person S corporation Strategy Works Best for These Taxpayers

The one person S corporation works best when someone makes either a high five or low six figure profit and then can pay a reasonably low salary. As suggested in the earlier, the approach also works best when the business tax return shows lots of tax-free fringe benefits.

Accordingly, many independent contractors working as skilled tradespeople, consultants and professionals can make the strategy work well.

Through 2025, an S corporation can also work with very high income taxpayers if the taxpayer qualifies for the Section 199A deduction by having the business pay wages. Big income real estate brokers, some doctors, software engineers, and a handful of other special case situations fall into this category.

Timing of Strategy

Regarding timing, by the way, a small business operating as an LLC throughout the past year—so the LLC existed on January 1 of the current year—can elect to be treated as an S corporation for year. Even rather late in the year. To do that the business owner or his accountant files a 2553 form with the IRS. And the business owner needs to pay a reasonable amount of shareholder-employee compensation before December 31.

Note: Technically, in order to elect S corporation status as of January 1 for some year, the IRS needs the 2553 form by March 15 of that year. The IRS allows late elections, however, if the business provides a good excuse.

Other small businesses practically want to wait until the start of the next year. And they want an LLC or corporation already formed by January 1 of that next year.

Example: Martha wants to operate her small business as an S corporation as soon as possible. But she doesn’t yet operate the business as a corporation or limited liability company. Accordingly, what she does is form an LLC late in the year and then elect to use S corporation status starting January 1 of the next new year.

Other Information Sources

If a small business wants to set up a limited liability company, we have free downloadable kits you can access at his page: downloadable limited liability company kits.

Over the years, we’ve accumulated quite a bit of background information about S corporations. If you’re just starting your research, you may find these blog posts useful: The Million Dollar S corporation Mistake, S Corporation Reasonable Compensation, and IRS S Corporation Shareholder Salary Data.

Finally, and as always, taxpayers want to discuss a strategy like this with their tax advisor. He or she knows the details of your specific situation. And this plug for our CPA firm: If you don’t have a tax advisor who can help, please consider contacting us: Nelson CPA.

Tip: If some accountant or consultant suggests that you can form a corporation or LLC late in the year (so say December of the current year) and then retroactively elect S corporation status as of January 1 of the current year. So months earlier than the corporation or LLC even exists? That person doesn’t understand enough about S corporations to be providing you with professional advice. Sorry.

The post Tax Strategy Tuesday:  One Person S Corporation appeared first on Evergreen Small Business.

The Build Back Better Act hits S corporation owners and active real estate investors a bit harder than some of us guessed.

In a nutshell? It subjects high income S corporation owners and active real estate investers to the net investment income tax. (Something they avoided to date.)

If you’re impacted, therefore, you want to understand the new law. And then you maybe also want to take steps to minimize the tax increase.

But let’s dig into the details…

How S Corporations and Active Real Estate Investors Taxed Prior to Build Back Better

To start, let me review how the net investment income tax (also known as the Obamacare tax) works today.

In the case of an S corporation earning $200,000 in profits, the business owner splits the profit into wages and a leftover amount called a distributive share. For example, an S corporation owner might split $200,000 of profit into $80,000 in wages and $120,000 in distributive share.

The business owner pays Social Security and Medicare taxes on the $80,000. But not on the $120,000.

Further, if she or he materially participates in the business? The owner pays no net investment income tax either.

Active real estate investors often, for purposes of net investment income taxes, enjoy a similar tax treatment. A high income taxpayer would usually pay net investment income tax on $100,000 of real estate investment income. But she or he probably sidesteps paying that tax if materially participating in an active real estate investment.

Build Back Better changes this, however. Starting in 2022, Build Back Better makes a high income taxpayer treat the S corporation or active real estate income as net investment income. That treatment potentially triggers the 3.8% net investment income tax on the S corporation distributive share or the active real estate investment income.

Net Investment Income Tax in a Nutshell

The 3.8% net investment income tax hits single taxpayers who earn more than $200,000 in modified adjusted gross income. It hits married taxpayers who earn more than $250,000 in modified adjusted gross income.

If some taxpayer pays the tax, the 3.8% tax gets levied against the lesser of the net investment income or the amount by which the taxpayer’s modified adjusted gross income exceeds those $200,000 and $250,000 thresholds.

For example, a single person who earns $210,000 in investment income pays the 3.8% tax on $10,000. Not on $210,000.

Most taxpayers can think about the net investment income “modified adjusted gross income” as equivalent to regular old adjusted gross income. But at the bottom of this blog post, I link to an example of what the new Section 1411 statute will look like if the version of the Build Back Better Act available when I wrote this blog post on November 15, 2021 is what Congress passes and the President signs.

And now lets talk about how Build Back Better impacts S corporation owners and active real estate investors. It’s a little bit tricky…

Which High Income Taxpayers Pay Tax

A single taxpayer treats her or his S corporation or active real estate investment income as net investment income and so potentially subject to net investment income tax if her or his modified adjusted gross income exceeds $400,000.

Married taxpayers treat their S corporation or active real estate investment income as net investment income and so potentially subject to net investment income tax if their modified adjusted gross income exceeds $500,000.

A married taxpayer filing a separate return treats her or his S corporation or active real estate investment income as net investment income and so potentially subject to net investment income tax if her or his modified gross income exceeds $250,000.

Let me give an example so you see how this works.

Say a single person earns $410,000 in S corporation income and $90,000 in W-2 wages and therefore enjoys $500,000 of modified adjusted gross income. Build Back Better treats the $410,000 of S corporation income as net investment income. And therefore this taxpayer will pay the 3.8% tax on $300,000 of that $410,000 of S corporation income. Note that the taxpayer pays the 3.8% on the lesser of the $410,000 of net investment income or the amount by which the taxpayer’s $500,000 of modified adjusted gross income exceeds $200,000–which equals $300,000.

A Phase-In Range Applies for Build Back Better S Corporation Tax

And then another wrinkle to be aware of: A phase-in range applies.

Single taxpayers see the tax phase in as the modified adjusted gross income rises from $400,000 to $500,000.

Married taxpayers filing joint tax returns see the tax phase in as the modified adjusted gross income rises from $500,000 to $600,000.

Finally, married taxpayers filing a separate tax return see the tax phase in as modified adjusted gross income rises from $250,000 to $300,000.

For example, say a single taxpayer earns $450,000 from an S corporation she or he materially participates in. Say that $450,000 equals the taxpayer’s modified adjusted gross income. With Build Back Better, this taxpayer treats that $450,000 as net investment income. But she or he doesn’t pay the 3.8% tax on the full $250,000 in excess of the $200,000 threshold for net investment income tax. Rather, because $450,000 is half way through the $100,000 phase-in range, she or he pays the 3.8% tax on half of the $250,000, or $125,000.

Some Initial Tax Planning Thoughts and Comments

Right now? We don’t even know if the Build Back Better Act will pass. And we don’t know what the final bill will say. But a handful of tax planning thoughts merit consideration…

Wait to Elect S Status?

First, this suggestion: An entrepreneur starting a new trade or business probably wants to wait on making any Subchapter S election until the dust settles on the Build Back Better legislative process. It seems very likely that applying the net investment income tax to S corporation income changes the attractiveness the S corporation option for some high income taxpayers and for some high potential ventures.

Consider Converting to Partnership?

A second thought: High income taxpayers with existing S corporations probably want to explore the mechanics of converting S corporations into partnerships.

As compared to an S corporation, a partnership (including a limited liability company) might mean that a high income taxpayer pays self-employment taxes on all the business income rather than net investment income taxes on a chunk of the business income.

But that treatment however should result in a new self-employment tax deduction. And it might also result in larger Section 199A and pension plan deductions.

Further, a partnership allows more flexibility in the tax accounting. And in the ownership. These tradeoffs might make the partnership option attractive…

No Do-it-yourself Corporate Liquidations

A third thought: Liquidating a corporation, including an S corporation, and reforming as a partnership probably triggers a bunch of taxable events. Accordingly, most high income taxpayers should work with their tax advisors to assess the costs and benefits of liquidating an S corporation to reform as a partnership.

This would not be a do-it-yourself project, in other words. Well, unless you’re a tax attorney, CPA or enrolled agent with corporate tax knowledge.

Smooth Income to Avoid Tax

A fourth general comment: High income taxpayers whose adjusted gross incomes bounce around the phase-in range–probably the usual case for affected S corporation owners? Yeah, these folks will really want to smooth their income going forward.

For example, a single person with modified adjusted gross income that holds steady at $400,000 annually avoids the Build Back Better tax.

But a single person who sees her or his income bounce between $300,000 one year and then $500,000 the next year, gets whacked with about $10,000 of net investment income tax every other year.

Work Harder to Find Deductions

A fifth comment related to scavenging more deductions. The marginal federal tax rates for some affected taxpayers get very high.

Affected taxpayers might be paying a base federal income tax rate of 35% for example. Another 10% to 12% due to the phase-out of the Section 199A deduction (if they are a specified service trade or business). Then another maybe 8% to 10% due to the phase-in of the net investment income tax.

A 50% or higher federal rate may mean taxpayers want to reexamine all the usual tax sheltering tactics. So bigger pension deductions. Or de-passified real estate losses. Stuff like that.

Remember Section 199A May Require S Corporation

Finally, a sixth comment: Even with the new tax, an S corporation may still make sense for some high income non-specified-service-trade-or-business taxpayers. Why? Due to the Section 199A deduction. Accordingly, don’t automatically assume an S corporation no longer makes sense. (Note though the Section 199A deduction expires after 2025.)

Other Resources You May Find Useful

First, here’s the government web page where you can get downloadable copies of the Build Back Better bill and related official documents.

Second, just in case you’re not used to mashing up new legislation with old existing statutes, here’s a Microsoft Word document that shows how Section 1411 looks if the Build Back Better Act passes. Note that the new bits appear in green.

A third small point worth mentioning: If you’re an active real estate investor, you may want to verify you’ve been sidestepping the net investment income tax in the past. Details here about how you do that correctly: Real Estate Investors and the Net Investment Income Tax. By the way? If you’ve been paying net investment income tax on your real estate investment income but should not have been, amend your open old tax returns. And get the refunds.

Fourth, this tangential remark: Partnership entities face both risks and opportunities related to maximizing their Section 199A deductions. More details here about this subject: Salvaging Partnership Section 199A Deductions.

Finally, this plug for our CPA firm: If you own an S corporation and need tax planning help with the new net investment income taxes on S corporations, know that we are available to help taxpayers with this analysis. Contact information appears here: Nelson CPA.

The post Build Back Better S Corporation Tax Hits High Income Taxpayers appeared first on Evergreen Small Business.

People have complained about the loophole, gosh, probably since President Eisenhower’s administration created it.

The triggering event? President Biden and the House Democrats’ tax proposal to subject working S corporation shareholders to the net investment income tax. But the situation is complicated. Messy.

So, I’m going to talk here about the slow death of the S corporation. Why it occurs. And what you can do if the death matters to your business. Or to the businesses of your clients.

One other thing to say as we start. I’m going to use rounded, really simplified examples here. That’ll make this discussion shorter. Easier to digest.

And then one high level point to start with? The death occurs because the new tax on S corporations ignores inflation. But let’s dig into the details.

How S Corporations Save Tax

To start, you need to understand how S corporations save entrepreneurs payroll taxes, including Social Security taxes, Medicare taxes, and then the Medicare surtax and net investment income tax (which are more commonly known as the Obamacare taxes).

Say an entrepreneur pays him or herself a fair salary. On that income, she or he pays Social Security taxes, and possibly Medicare and Obamacare taxes.

But say the business the entrepreneur runs generates another $100,000 of business profit in addition to those wages

On that additional non-wage income, the entrepreneur still pays income taxes.

But with an S corporation she or he doesn’t pay payroll taxes. And that is how S corporations save business owners taxes.

In comparison? If the entrepreneur operates as a sole proprietorship and makes the exact same amount of money? She or he essentially pays both income and payroll taxes on all the profit.

Furthermore, the same basic accounting occurs if an entrepreneur works as a partner in a partnership. In that situation, the partner pays both income and payroll taxes on all the profit.

Note: We have a long discussion about how S corporations save taxes here: The Million Dollar S Corporation Mistake.

How Biden Tax Plan Starts the Slow Death of S Corporation

What President Biden proposes? And what the House Ways and Means Committee puts into writing? A rule that says an entrepreneur pays the 3.8 percent Obamacare tax if the entrepreneur’s income rises high enough.

Specifically, the rule says that if an entrepreneur files as a single person, she or he pays the 3.8 percent Obamacare tax once modified adjusted gross income hits $400,000. And if an entrepreneur files as a married person, she or he pays the 3.8 percent Obamacare tax once modified adjusted gross income hits $500,000.

A clarification: A taxpayer pays the Obamacare tax on the amount by which modified adjusted gross income exceeds the threshold. A single person with a modified adjusted gross income of, say, $410,000, pays no 3.8 percent tax on that first $400,000. Only on a part of that last $10,000.

Who Gets Hit Initially with New S Corporation Tax

Very correctly, Mr. Biden and House Democrats point out that in 2021, those modified adjusted gross income thresholds mean basically only taxpayers in the top one percent get hit.

For the record, I double-checked. The Democrats are absolutely right.

Today? The new tax on S corporations ignores roughly 99 percent of the taxpayers in the country.

Note: A great paper that discusses and coincidently profiles who the Biden tax plan targets appears here: Capitalists in the Twenty-first Century.

The thing that people miss? And something, frankly, entrepreneurs, business owners and professional advisors need to pay attention to?

Slowly but efficiently, inflation expands the number of people subject to the Obamacare tax over time.

Why? Because tax law fails to adjust those $400,000 and $500,000 thresholds for inflation.

And what that means is, more quickly than you might guess? A larger and larger group of S corporation shareholders pay the Obamacare tax.

Furthermore, eventually, inflation will eliminate the payroll tax savings an S corporation has traditionally delivered.

Specifically, once inflation pushes up a shareholder-employee’s reasonable wages to the Social Security maximum taxable earnings limit and pushes up that person’s household taxable income to the Biden net investment income tax trigger? The S Corporation no longer saves business owners payroll taxes.

The process takes time. But the effect shows up sooner than you might guess.

The Original Obamacare Tax Example

To give you a concrete example, you only need to look at the original Obamacare tax formula.

The original flavor of the Obamacare tax formula hit single taxpayers earning more than $200,000 of modified adjusted gross income. And it hit married taxpayers earning more than $250,000 of modified adjusted gross income.

In 2010 when Obamacare passed, people talked about those income thresholds representing top one percent situations. That sounds about right.

And note that in 2010 when Obamacare passed, the Social Security tax applied only on the first $106,800 of earnings.

Above that earnings level, any additional wages got hit with either the standard 2.9 percent Medicare tax or the 3.8 percent Obamacare tax.

The 2.9 percent tax applied to earnings over the $106,800 maximum taxable earnings threshold but under the $200,000 threshold.

Then above $200,000? That 3.8 percent Obamacare tax rate kicked in.

But the thing is? That bit of tax law also doesn’t adjust that $200,000 or $250,000 value for inflation. And that means the 2.9 percent bracket has shrunk in size due to inflation.

With a dozen years of inflation since the Obamacare law passed, many more people pay the Obamacare tax. Next year, the Social Security maximum taxable earnings limit will probably equal roughly $147,000. That’s my guess. That means the 2.9 percent payroll tax bracket shrinks to roughly $53,000. So almost half the size of the $93,000 bracket that existed when Obamacare passed.

All that income previously taxed at 2.9 percent? Tax law now levies instead either a 15.3 percent Social Security tax or the 3.8 percent Obamacare tax. And in a few years? Well, very possibly by the time Mr. Biden leaves office? The 2.9 percent Medicare bracket won’t even exist.

In a few years, in other words, the 15.3 percent tax may apply to the first $200,000 or more of income a person earns. And the 3.8 percent Obamacare tax will apply to any amounts in excess of that $200,000.

The Slow-Motion Death of the S Corporation

Now let’s return to the slow-motion death of the S corporation…

And a first point just so nobody overreacts: The death of the S corporation? It will take time. Lots of it.

I’m talking, and we’re worrying, about something that occurs incrementally over the next couple of decades or longer.

But it’s certainly worth noting that in coming years the S corporation tax savings steadily shrink. Especially for successful entrepreneurs.

Specifically, as inflation requires shareholder-employees to bump their salaries and so pay more and more of the 15.3 percent Social Security tax? And as more and more shareholder-employees pay the 3.8 percent Obamacare tax? Well, yeah, you need to think about all this. And probably starting as soon as the law passes. If it passes.

Note: Nonworking S corporations may already be subject to Obamacare taxes on their shares of S corporation profits as explained here: Avoiding Net Investment Income Tax.

Actionable Insights for Bid Tax Plan S Corporation

In fact, if you’re an entrepreneur or business owner, I think you want to consider three issues:

First,  if your business needs wages to qualify for the still generous Section 199A deduction Congress plans to provide through 2025? The S corporation option may still save you tax. The current Congressional Democrats’ tax proposal, which could easily change between the time I write this and the time you read it, gives business owners up to a $400,000 or $500,000 Section 199A deduction. So, a 199A deduction on roughly $2 million to $2.5 million of income. An S corporation may therefore make sense temporarily if only to create wages for the Section 199A deduction. (That deduction allows taxpayers to avoid paying tax on the last 20 percent of their business income.)

Second—and this is an however—if your situation revolves around a business or venture that may or will run decades? Yeah, you probably want to revisit your entity choice. Something else may make more sense. Let’s be honest. The historical reason to be an S corporation? So you save payroll taxes. The historical problems with an S corporation? You also lose flexibility and give up other tax benefits. Accordingly, if you lose or will lose payroll tax savings as compared to what you planned or hoped? Yeah, you need to consider other options. Like a limited liability company treated as a partnership. Or a traditional C corporation.

Third, and I am not going to go into details here, but you of course do have other ways to mitigate or sidestep the taxes Congressional Democrats and Mr. Biden propose hitting S corporations with. Your tax advisor, in fact, has a long list of planning techniques she or he can dust off and then use to dial down the taxes you ultimately pay. You may just need to be a bit more proactive. And go to a little more work.

The post Biden Tax Plan Starts Long Slow Death of the S Corporation appeared first on Evergreen Small Business.

And you hear lots of rules of thumb (including some at this website).

And then people talk… you know, about what you can really do. (Hey. We’ve all heard the stories…)

Which is why it’s useful and interesting to sift through actual IRS S corporation salary data. So I want to do that here.

A Quick Review of the Basic Rule

Before we start that sifting, though, let’s recognize and restate the basic rule for setting S corporation shareholder-employee salaries.

That basic rule goes like this: You need to set a salary that some other firm would pay someone for doing similar work.

Furthermore, here’s another good idea. It’s always wise and smart to dig up some real salary survey data for your area for jobs like you’re looking at. (We particularly like Bureau of Labor Statistics data which you can get to from here.)

So keep that in mind as you continue reading. And now let’s look at the data.

Average S Corporation Shareholder Salaries

The table that follows shows average revenues, officer compensation deductions and profits for S corporations operating in roughly a couple of dozen industry categories.

The data comes from the 2017 1120S tax returns S corporation owners filed with the Internal Revenue Service in 2018. (Source: SOI Tax Stats – S Corporation Statistics .)

Understanding the Table’s Salary Data

Let me quickly describe the table’s data so no confusion exists. We can do this by talking about the first row.

Row one in the table reports on the average revenue, officer salary deduction and net profit considering all 4.7 million S corporations.

Make sure you understand those numbers: On average, an S corporation generates roughly $1.7 million of revenue, deducts $62,046 of salaries expense for all its officers, and reports just over $100,000 of net income.

Tip: Remember too to mentally adjust the numbers for inflation that’s occured since 2017.

And then reading down the rows of the able, look at the other averages for the industry categories listed: mining, construction, manufacturing and so on.

You can probably glean some insights from this information. But you’ll want to keep in mind a few facts.

The S Corporation Salaries Number is the Deduction

A first thing to note, for example, the S corporation salaries value the IRS data lets you calculate? The value represents the average deduction.

So, that $62,046 average just referenced? That’s the average deduction for officer compensation. The amount might represent one officer making $62,046. Or two officers making $31,023. Or three officers making–well, I don’t need to go on. You see how this works.

Officers Not Necessarily Shareholder Employees

A quick related note: An officer isn’t necessarily a shareholder.

Now most of the officer compensation deduction probably does go to shareholder-employees. But maybe not all.

In any case, that’s something else to keep in mind.

Means Probably Higher than Medians

One final thing to remember: The table above shows mean averages: mean total revenues, mean officer compensation deductions and mean net profit.

The reality to recognize about mean averages? A mean value probably exceeds by a large amount the median, or midpoint, value.

For example, suppose you or I calculate the mean and the median of the following ten officer compensation deductions:

• Three officers making $20,000 each
• Six officers making $40,000 each
• One officer making $300,000

The median, or midpoint, officer deduction equals $40,000 in this case.

The mean, or average, officer deduction in this case, however, equals $60,000.

I calculated this as ($20,000+$20,000+$20,000+$40,000+$40,000+$40,000+$40,000+$40,000+$40,000+$300,000)/10

You see what happens with the mean average. That big number–the $300,000–pulls up the average.

An Example of How to Use the Salaries Data

Given all of the above, then, how might you use this data?

Well, you can probably use the average officer deduction values as a benchmark for setting S corporation shareholder salaries for average-sized businesses within a category.

As an example, look at the the average S corporation that operates within the  “professional, scientific and technical services” category.

On average, firms within that category of S corporations per the table report revenues of just over $800,000. The officer compensation deduction equals about $72,000. And then the business profit roughly equals $92,000.

If you run similar sized professional services firm? One generating similar profits? You’re probably on pretty safe ground paying yourself around $70,000.

Again, remember that $70,000 represents a deduction amount–not a salary amount. Also it’s a mean not a median. Finally, it might represent not just shareholder-employees but non-shareholder officers. So don’t forget that.

Nevertheless, even given these factors, the value probably provides a pretty reasonable benchmark to consider when setting a salary for a firm in the same industry category.

Getting Additional S Corporation Average Salary Data

One final quick comment. In the past, the IRS published statistics that allowed for building a much longer list of average revenues, officer compensation and net profit by industry.

If you’re interested in a longer list, therefore, you may want to make the calculations yourself using some earlier years’ datasets. (We did calculate and show that longer dataset for 2013 at our S corporations Explained website. You may want to peek there.)

Other S Corporation Salary Resources

We provide some basic guidelines here: S Corporation Salary Rules

Firms wrestling with trading off Section 199A deductions with S corporation payroll tax savings may be interested in this discussion: S Corporation Sharehold Salaries adn the Section 199A Deduction

We’ve got some more tips and guidelines here for setting S Corporation Reasonable Compensation

Finally, here’s a quick overview of some rules for Safe Harbor S Corporation Salaries

The post IRS S Corporation Shareholder Salary Data appeared first on Evergreen Small Business.

Call us crazy. But we love the way they help entrepreneurs reduce payroll taxes (thereby making it easier to grow a business). And the way they create W-2 wages (which successful small businesses need to get a Section 199A deduction).

But the time of Covid-19 throws a monkey wrench into the gears. Why? Well, usually, you can easily make an S corporation election. Even a late one. But now? Yeah, now that doesn’t really seem to work.

Accordingly, this blog post explains the rules for making S elections. And then it discusses how late elections worked in the past and why the “old way” probably doesn’t work well anymore. Finally, it ends with an approach we think you can still use to make timely or late S elections in this era of Covid-19.

Note: This blog post doesn’t explain at a granular level how you save money with an S election. But you can poke around this blog and get lots of information. A good place to start your research? Million Dollar S Corporation Mistake.

Eligibility for S Corporation Tax Treatment

The S corporation rules work like this. An eligible entity (so usually either a corporation or a limited liability company) can make an election to allocate the entity’s income and deductions to its owners—and thereby make them pay the income taxes.

A couple of important points though. First—and people miss this sometimes—you need an eligible entity in existence at the point you want to make the S election and at the point you want to make the S election effective.

Example: Two business owners, Adam and Ben, want to elect S status. Both operate as limited liability companies. Adam formed his LLC on January 1, 2020 while Ben formed his on December 1, 2020. In early 2021, both entrepreneurs decide to make an S election. The earliest effective date Adam can use? January 1, 2020. For Ben? December 1, 2020.

A second point: Only eligible entities may make the election. The rules get a little complicated for firms operating in weird situations. But the usual eligibility rules, provided by Section 1361 of the Internal Revenue Service, highlight the main qualifications:

• No more than 100 shareholders (in general–but families count as one shareholder usually).
• No nonresident aliens for shareholders (so all owners need to be U.S. citizens, permanent residents, and other taxpayers that are really close to these things).
• A single class of stock (so all shareholders and LLC members get shares of income and deductions and of distributions proportionate with their ownership percentage).

Electing S Corporation Tax Treatment

If an eligible entity wants to make an S election? Well, thankfully it’s pretty easy.

In most cases, the corporation or LLC files a fairly simple three-page form, the 2553, which identifies the entity, specifies the effective date desired for the election, and then includes signatures from all the shareholders.

And then the other thing to note: Timing rules exist. Specifically, a 2553 election can be filed in the tax year before the date the entity wants the election effective.

Example: Adam decides he wants to start operating as an S corporation in 2021. He can file the 2553 anytime during the preceding tax year, which is calendar year 2020.

And a firm can also make an S election by filing after the year starts. Specifically, by the 15^th day of the third month. That works, too.

Example: Ben wants an LLC he formed on December 1, 2020 to operate as an S corporation starting on January 1, 2021. He can file his 2553 on or before March 15, 2021. (Note that he can’t file his election before December 1, 2020.)

The Late S Corporation Election Exception

Okay, so here’s something else you want to know if you’re thinking about all this. And believe it or not,  lots of tax accountants don’t know this.

You can file your S election late. Really late. Embarrassingly late.

That “15^th day of the third month” rule? Ignore that.

What you don’t want to ignore, however? The IRS’s current rules for making a late S election (currently published in Revenue Procedure 2013-30.) You can get a good understandable overview here at the IRS website: Late Election Relief.

The two main things to know about late elections no matter what? First, you need to follow the revenue procedure for making the late S corporation election. (Mostly that means you need to justify your bungle of the timing and then flag the election as being a “LATE ELECTION FILED PURSUANT TO REV. PROC. 2013-30.”)

Second, you need to have reported your income consistent with the S corporation accounting rules. And the “consistent with the S corporation accounting” thing? What that boils down to, in many cases, is you paying shareholder-employees payroll during the year you want to elect S corporation tax treatment for.

Example: Charles had an LLC for all of 2020 and wants to elect S corporation tax treatment for 2020. It’s January of 2021, however. So nearly a year late. He may be able to make a late election. But he practically needs to have paid himself as a shareholder-employee during 2020.

And then there’s the one other thing to consider. The Covid-19 impact on S elections. Which is really the reason I’m even writing this blog post.

But first a quick digression…

The Late S Election Statement

To make a late S corporation election, your 2553 needs to include a statement on page 1 that says:

The corporation intended to be classified as an S corporation as of the date entered on line E of Form 2553. The corporation failed/fails to qualify as an S corporation on the effective date entered on line E of Form 2553 solely because Form 2553 wasn’t filed by the due date. The corporation has reasonable cause for its failure to timely file Form 2553 and has acted diligently to correct the mistake upon discovery of its failure to timely file Form 2553. Form 2553 is being/will be filed within 3 years and 75 days of the date entered on line E of Form 2553.

Your statement needs to describe the reasonable cause. Something like, “I thought my accountant was handling the election.” Or, “I called the IRS and misunderstood what the customer service person said.”

Finally, the corporation must, according to the Form 2553 instructions, confirm the following statements are true:

The corporation and all its shareholders reported their income consistent with S corporation status for the year the S corporation election should have been made, and for every subsequent tax year (if any), at least 6 months have elapsed since the date on which the corporation filed its tax return for the first year the corporation intended to be an S corporation and neither the corporation nor any of its shareholders was notified by the IRS of any problem regarding the S corporation status within 6 months of the date on which the Form 1120-S for the first year was timely filed.

By the way? That quoted language above comes directly from the 2553 form instructions.

Covid-19 Late S Corporation Elections

During the Covid-19 pandemic, the IRS has struggled to keep up with the paperwork.

And S elections filings (using that 2553 form)? They’ve gotten bogged down too.

An eligible entity filing a 2553 form in the usual manner—such as with a paper by-mail filings or by faxing in the 2553 form—can find the IRS takes, gosh, months? Or months and months?

Which means you can’t really know whether you’ll be able to timely file your first S corporation tax return by the deadline. Or even, if we want to pessimistic, by the extension deadline.

Example: Charles might think he can file a late S corporation election in the fall of 2020 using an effective date of January 1, 2020. But that election may not be processed by the March 15, 2021 deadline his 2020 S corporation tax return is due. If he does file his 1120S and the 2553 election hasn’t been processed, the 1120S filing fails.

Fortunately, you probably have a workaround. You can file the 2553 form that makes the S election with the 1120S tax return.

This approach of filing simultaneously the election and the first tax return should work whether you file by paper or electronically.

What the dual filing approach does? It prevents the IRS computers from trying to process your first 1120S S corporation tax return before the IRS has accepted your 2553 election.

Other Resources

S Corporations and the Section 199A Deduction

S Corporations, Section 199A, and the Optimal Shareholder-employee Salary

Downloadable Free LLC Formation Kits (which business owners can use to get an S Corporation setup)

Finally, step by step instructions for completing the 2553 Form for Washington state appear here, Steps for Electing Sub S Status for Washington LLCs and Corporations, but you can probably use these step-by-step instructions for any other state, too.

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Well, okay, this is awkward… but somehow, no one quite knows how, the S corporation hasn’t paid enough payroll to the shareholder-employee.

Maybe the first quarter, the firm lacked cash. Second quarter, things got really busy. Then, you know, summer.

And now, with just a few weeks to go for the year, the S corporation hasn’t paid some shareholder-employee enough payroll. And very possibly the firm doesn’t have adequate cash flow to load enough payroll into the last quarter.

This predicament is a serious problem. As you know if you’re reading this, the IRS requires S corporations pay shareholders a reasonable wage. So what can someone in this situation do? Here are some ideas.

Tip #1: Size the Problem and Assess the Severity of the Problem

A first tip, perhaps obvious. Before you get too worried, size up the problem and assess the severity of the payroll bungle.

Regarding the size, come up with a number that you need to “make” to meet the IRS requirement of reasonableness.

In other words, maybe you always planned to pay some shareholder $80,000. But is $60,000 actually “enough?” And have you in earlier quarters or year-to-date payrolls already paid some of this?

For example, does $60,000 “work” and have you already paid $30,000? And so is the problem actually a potential $30,000 shortfall? You want to know this number.

A related factor to consider. The IRS, if you shortchange them on the payroll taxes and they spot it, re-categorizes distributions or other shareholder payments as payroll. That’s the risk you face if you don’t do enough payroll.

Accordingly, say you quite honestly do need another $30,000 of payroll to achieve “reasonable compensation.”

If you’ve paid zero distributions, true, you should pay an additional $30,000 of wages. But your risk if you don’t pay the additional wages is essentially zero. The IRS needs distributions or similar payments it can recategorize to force you after the fact to pay payroll and to levy penalties.

Tip #2: Re-categorize a Previous Quarter’s Distributions

But say you find yourself short. And need to, before year end, bump up your wages. A first thing to look at: Can you reclassify shareholder distributions made in a previous quarter as wages?

For example, say you paid out generous distributions in the third quarter. What you might do is belatedly treat $16,000 of these payments as payroll to the shareholder-employee.

If you’re running a small S corporation with just a single shareholder who also happens to be the sole employee, you may be able to file a 941 for a previous quarter that shows no federal taxes withheld and $2,448 of Social Security and Medicare taxes owed. You can file this 941 and pay the $2448 tax deposit with the form.

The tax deposit may be late. So, you’ll get hit with penalties and interest. But if your 941 return was due Oct 31 and it’s only a few days past that date? You may not be that late.

Note: The IRS requires you to make payroll deposits electronically using their eftps.gov payment system. However, if you owe the IRS less than $2,500 for the current quarter or the preceding quarter, you can pay the taxes for the current quarter with a timely filed 941 return. (Source: IRS Tax Topic 757.)

Tip #3: Handle any Shareholder-employee Health Insurance Correctly

A quick idea: Be sure you “do” the bookkeeping correctly for any shareholder-employee health insurance.

An S corporation shareholder-employee with, say, $10,000 of annual health insurance should treat the health insurance as wages subject to income taxes. Note that these “faux” wages aren’t subject to payroll taxes like Social Security and Medicare. As a result, they don’t really help you create more reasonable compensation. But they improve the optics of your tax return. And these “faux” wages can be reported on next quarterly 941 tax return.

Note: We describe in another blog post how to report shareholder-employee health insurance.

Tip #4: Round-trip Some Money

Another idea, which more folks should consider…

If you have any way to put funds back into the S corporation and can then immediately return those funds to the shareholder as payroll, that can help you fix the unreasonably low compensation problem.

For example, say you have a credit card with $10,000 of available credit. If you take a cash advance for $10,000 and use those funds for $10,000 of payroll, you’ll partially address the shortfall.

Note: Because of the employer and employee payroll taxes, $10,000 of wages require more than $10,000 of cash. The 15.3% combined employer and employee Social Security and Medicare taxes, for example, mean that $10,000 of payroll costs at least $10,765. But the cash you return to the shareholder-employee equals $9,235.

A tangential comment: You can of course combine techniques. So, maybe you use tip #2 to re-categorize a previous quarter’s distributions and get $16,000 of wages in that way. And then maybe you get another $10,000 of wages by using Tip #3. Finally, maybe you get $10,000 of wages or whatever by using Tip #4.

Tip #5: Talk with Your Accountant about Reporting Wages without Actual W-2s

One last half-crazy idea some accountants will consider: You and your accountant may decide to report wages on your 1120S tax return anyway (even though you didn’t actually do payroll). When you do this, you then report the income as subject to self-employment taxes on your 1040 return.

In this case, if you do the bookkeeping correctly, you pay all the income taxes owe and you pay all the Social Security and Medicare taxes you owe.

Note: The one tax you “short” the IRS is the federal unemployment tax, which runs $420 a year or less. You only short the IRS on FUTA, though, if you pay zero real owner wages.

Let me be clear. This approach clearly breaks the rules. Many CPA firms (including our CPA firm) won’t do this. But some will. And to be objective, this approach probably is the lesser evil in some situations.

A Little Sidebar Here about Tip #5

Let me provide a bit more context too…

At an IRS symposium for several hundred tax practitioners a few years, a CPA stood up and asked one of the IRS’s internal S corporation experts about this “no actual W-2 wages” technique.

The IRS employee responded, “Yeah, you’re not supposed to do that.”

The CPA, a nice woman, answered “I know that. But how bad is it if we have a client do this.”

The IRS employee then repeated his “You’re not supposed to do that” comment. Which she answered with her “I know that but how bad is it” comment.

And they went around like this several more times.

My takeaway? Absolutely, people shouldn’t use this hack. But the IRS S corporation expert seemed to suggest that though IRS would never condone the sloppiness, they probably weren’t going to spend too much worrying about situations like this.

And two related tidbits for tax accountants reading this and now wondering if I’ve fallen off my rocker. If you look at the 1120S form instructions for reporting shareholder-employee wages, you can squint and in the right light read the instructions to say you do have to do this. You can’t in other words not report at least reasonable wages.

Also, it looks to me as if the professional tax software programs provide check boxes to allow just this sort of tomfoolery.

Again, I am not saying this hack qualifies as a good idea. Like I noted, we won’t do it. But I understand the logic of the folks who do.

Two Final Comments

Two final comments. First, if you find yourself with a late S corporation payroll problem, make the experience a learning moment. Do a better job going forward next year.

Tip: Probably the best practice? Outsource the payroll to one of the popular payroll services. (We use Gusto, by the way. For what that’s worth…)

Second, if you just can’t deal with the shareholder payroll thing? Maybe you dissolve the S corporation and go back to operating as a sole proprietorship or partnership. That dissolution saves you from having to do owner payroll.

The post Late S Corporation Payroll Hacks appeared first on Evergreen Small Business.

More specifically, if you qualify for the home office deduction, you ought to take the deduction. But let’s go over the mechanics. This gets a little bit complicated. (Sorry.)

The Usual Rules for Home Office Deduction

As a refresher on home office deductibility, a business owner may be able to deduct home office expenses if she or he uses a home office regularly and exclusively for business and if the home office represents the principal place of business.

The IRS website provides a longer discussion here, but the deduction works pretty simply.

Example 1: How Home Office Deduction Works

Say your sole proprietorship operates out of your house. Further, say the mortgage interest annually runs $10,000, that property taxes run another $5,000, and that utilities and repairs total another $3,000.

All totaled, then, your home operating expenses run $18,000 a year

One needs to consider depreciation, too. But say, to keep things simple, that you also get to include $10,000 a year of depreciation in your calculations.

Total expenses in this example run $28,000 a year once you combine the operating expenses and the depreciation.

If a home office amounts to ten percent of the structure, one could with these costs deduct 10% of $28,000 or $2,800 in home office expenses.

Note: In the case of a sole proprietorship, you show your tax accounting for the home office deduction on a form 8829.

Nothing to Get That Excited About

In spite of the easy math, I was never that big a fan of the home office deduction.

True, as the preceding example 1 shows, you could put a $2,800 deduction on the tax return and thereby save some taxes.

But with a home office deduction, mostly you or your accountant simply moved deductions around.

For example, $1,000 of the $10,000 of mortgage interest moved from Schedule A’s list of itemized deductions to the 8829 form that tallies the home office deduction.

Similarly, $500 of the $5,000 of property taxes moved from Schedule A’s list of itemized deductions to the 8829 form.

You do get $1,000 of depreciation deduction in a situation like that illustrated above… but when you sell the home, you recapture that $1,000 as income.

In the end, then, the only incremental tax savings came from the extra $300 of deduction created by deducting 10% of the utilities and repairs.

That $300 for most taxpayers meant $30 to $50 of income tax savings. Which seems pretty inconsequential.

No, no, I hear you.

Of course, $50 matters. But how much fiddling do you want to go to on your tax return to get an extra $50? And if you’re paying your accountant $200 an hour, you’re not saving money by having him or her do this work.

Note: With a sole proprietorship, just to be accurate, the total tax savings can amount to a bit more. The home office deduction saves not just income taxes but also self-employment taxes.

S Corporation Home Office Deduction Wrinkles

And then here’s the other thing when you look at doing this deduction for an S corporation: The whole S corporation thing complicates the deduction.

Normally, you can’t cleanly take a home office deduction on an S corporation tax return.

Unlike the situation with a sole proprietorship and that 8829 form mentioned a moment ago, no tax form exists for throwing a home office deduction onto an S corporation tax return.

And in fact, tax law sort of prohibits an employer from paying home office expenses to employees. (See Section 280A(c)(6).)

Accordingly, the right way to deduct home office expenses on an S corporation tax return goes like this:

1. The S corporation creates a formal reimbursement arrangement (called an “accountable plan”) to pay employees for their business expenses including the expenses of setting up and operating a home office.
2. Employees then regularly (say monthly) request reimbursement for business expenses, including home office expenses.
3. The S corporation pays those business expenses, carefully applying the rules of the “accountable plan” reimbursement arrangement.

Example 2: Simple S Corporation Home Office Deduction Example

Here’s a simple example of how this reimbursement works…

Mike, a shareholder-employee, works out of a home office for his S corporation, Acme Supplies.

Using its “accountable plan,” Acme Supplies reimburses Mike for the actual business expenses he pays each month, including the actual expenses he incurs for operating a home office.

As long as Mike and Acme Supplies follow the accountable plan’s rules, the reimbursed expenses count as a valid business deduction on the Acme Supplies tax return.

If Mike’s home expenses run $28,000 a year and his home office represents 10% of his home, the above gambit lets Acme Supplies reimburse Mike for and also deduct $2,800 of expenses.

Importantly, the reimbursed expenses don’t count as income to Mike.

You can now really see why the accountants often didn’t get that excited… People (mostly the accountants) may be going to quite a bit of work to save $30 or $50 of taxes a year.

Note: With an S corporation, the home office gambit saves income taxes but not self-employment taxes.

New Deduction Rules Change Home Office Calculus

Nevertheless, as my CPA friend pointed out, things work differently now. And the basic reason is itemized deductions just aren’t worth as much anymore.

First, starting in 2018, most people won’t itemize. Rather, they’ll just take the $12,400 standard deduction for a single person or the $24,800 standard deduction for a married person.

Second, and sort of related, the two largest components of the home expenses—mortgage interest and property taxes—may be limited even if someone does itemize.

Only $10,000 of state property and income or sales taxes are deductible, for example.

And interest on a large mortgage (over $750,000) may be limited too. (See our new mortgage interest deduction blog post for details.)

Given this, someone who adds a home office deduction to their tax return starting in 2018 may not be simply moving deductions from one page of a tax return to another page.

Rather, a taxpayer may be dramatically increasing deductions. And in some cases, the taxpayer may be sidestepping around mortgage interest and state tax limitations.

Example 3: The New Home Office Deduction Economics

Here’s an example of what I mean.

Continuing with the first example introduced, assume an S corporation operates out of the shareholder-employee’s house. Again assume the mortgage interest annually runs $10,000, property taxes run another $5,000, and utilities and repairs run another $3,000… and that the depreciation comes to $10,000 a year.

Home operating expenses and depreciation in this simple example total $28,000.

If a home office takes ten percent of the home, voila, $2,800 in home office expenses.

Assume, however, that the homeowner isn’t itemizing. Assume he takes the standard $24,800 deduction because he’s married.

In this case, the taxpayer loses nothing by moving $2,800 of home office deductions onto the business tax return.

No other schedule of deductions—like Schedule A’s list of itemized deductions—gets plundered for the deductions. The home office deduction is all gravy.

A small business owner in this situation may be looking at $300 to $700 in true annual additional tax savings because the return’s total deductions have grown by nearly $3,000.

You see what my CPA friend is talking about right?

Structuring the Reimbursement Arrangement

Some cautions…

An “accountable plan” reimbursement arrangement like the one vaguely described above creates all sorts of opportunity for taxpayer tom-foolery.

Accordingly, predictably, the Internal Revenue Service says the reimbursement arrangement needs to operate in a very business-like and common-sensed manner.

Specifically, you and I need to apply the Section 1.62-2(d)(1) regulations. Those regulations say the employer needs to reimburse an employee or shareholder-employee for appropriately substantiated expenses tightly connected to the business. The employer needs to quickly reimburse employees. Employees need to return over-payments.

You probably want to read the regulation if you’re going to do this. (Or review the rules with your accountant.)

And do do a good job on the paperwork and with your record-keeping. (One website suggests using the  8829 home office deduction form to make the calculations and help document the deduction even for an S corporation. And that seems like a pretty good idea.)

Example Accountable Plan

Here’s an example accountable plan document. Note that you can copy and paste the italicized text below into another document and then replace every occurrence of Acme Supplies with your firm name.

Acme Supplies IRC Sec. 62(c) Accountable Plan

Acme Supplies hereby establishes a IRC Section 62(c) accountable plan that implements and fully complies with Regulation Section 1.62-2.

Refer to Regulation Section 1.62-2 for detailed requirements—since Regulation Section 1.62-2 by this reference describes and controls the operation of the Acme Supplies accountable plan—but to generalize Acme Supplies will reimburse employees for ordinary and necessary business expenses of Acme Supplies that employees and shareholders directly pay as long as employees or shareholders fully substantiate these expenses by providing receipts and any additional documentation required by Acme Supplies.

Note that for travel related expenses, employees must provide not only the receipts but also substantiate the time, location and business purpose of the expense as per IRC Section 274(d) and its related regulations.

Employees may receive advances such as for upcoming travel up to 30 days in advance.

Employees must account for expenses paid or incurred within 60 days.

If Acme Supplies overpays employees, employees much refund overpayments or unsubstantiated amounts with 120 days.

A Final Warning and a Clarification

Let me close with a warning and then also a clarification.

First, the warning. This accountable plan stuff matters for more than just an S corporation home office deduction. If you don’t operate an accountable plan, you by definition operate a nonaccountable plan. And that’s bad news. With a nonaccountable plan, tax law requires the employer to add reimbursements to wages. So reimbursements become taxable income to employees.

Note: The new tax law eliminates the miscellaneous itemized deduction, which in past included employee business expenses.

Second, a clarification: If you rent your home and your home includes a valid home office and you operate your business as a sole proprietorship, your situation works differently than what I describe here. You also save more money with the home office deduction because the deduction shelters your income both from income taxes and self-employment taxes.

Other Resources You Might Find Useful

Somewhere on this page, you will see an advertisement for your “Setting Low Salaries for S Corporations” monograph.

If you have questions about how to optimize your S corporation shareholder-employee salaries, you might look into that resource. We wrote the monograph for tax practitioners, but many veteran S corporations find it a useful resource.

Earlier in this post, we mentioned another related blog post connected to the new tax law: New Mortgage Interest Deduction Rules. If you plan to deduct your mortgage interest or home equity loan interest, you may find that post useful.

The rules for deducting meals and entertainment expenses have changed for 2018 and later years. All business owners want to make sure they understand the new rules. Here’s a blog post that describes this: Meals and Entertainment Deductions 2018 and Beyond.

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