[Updated for 2019]
For those business owners that are already operating as S-Corps, this is the time of year to dial in your salary level. When it comes to tax strategies for entrepreneurs, I am convinced that the S-Corporation (S-Corp) is one of the most powerful long-term strategies to build upon.
The tax benefits, audit protection and foundation for other tax deductions are absolutely amazing in an S-Corp. For those who haven’t quite caught the vision or potential of the S-Corp, let me make a few important points and explain why they are so efficient and some of the benefits you are missing out on.
S-Corps: The Reason Why
The problem we’re trying to solve is that if you sell products or services, receive a commission, flip properties or receive 1099s and generally create ordinary income with a business, you will pay self-employment tax of 15.3 percent on all your net income if you are a sole proprietorship, whether you have an LLC or not.
The S-Corp allows you to minimize this dreaded self-employment tax. When using an S-Corp, your share of the company’s net income will not be subject to self-employment (SE) tax. (SE tax is a combination of Social Security and Medicare taxes also referred to as FICA.)
In 2019, the tax is 15.3 percent on the first $132,900 of net income (this amount is adjusted for inflation annually), then 2.9 percent on everything above that. Moreover, at $200,000 single and $250,000 married filing jointly (adjusted gross income or AGI), the Affordable Care Act (ACA) kicks it up another .9 percent, for a whopping total of 3.8% for high income earners.
However, the S-Corp allows owners to take reasonable payroll wages through a W-2 that escapes the SE and ACA taxes on the net. See the Payroll Matrix below.
Retroactive Election – You still have time in 2019
Most small-business owners and even some tax preparers don’t realize that you can make a retroactive election to be an S-Corp for 2019 if you already have been operating as an LLC all year long. Your CPA can help you with the procedure and make reference to the proper revenue procedures to include with your Form 2553. Many believe there is a hard and fast 75-day rule at the beginning of the year to make this election for all of 2019. This is certainly not the case. Talk to your CPA to follow the correct procedure to get a retroactive election accepted.
Year-end tip: Make a retroactive election for your LLC to have an S-Corp for all of 2019, and get your payroll allocation completed before year-end.
Choosing the Proper Payroll Level
In regards to payroll and net income planning, we consistently encourage our clients to allocate at least one-third of their net income to “wage earnings,” and the remaining amount can flow out as “net income” not subject to SE tax. However, please know this is a starting point and every taxpayer is different. It’s important to maintain this procedure through proper payroll planning.
Here is a diagram I have referred to as the “Kohler Payroll Matrix” over the years. This is an updated version since the passing of the Tax Cuts and Jobs Act effective in 2018, and can be a useful visual guide in determining the proper salary level in your S-Corp from year to year.
You’ll see that I begin the diagram at $50,000 of net income and a 50 percent payroll allocation at that level. As such, when taking the operational costs of maintaining an S-Corp into account, it typically doesn’t make sense to utilize the S-Corp unless you’re making a net income of at least $40,000.
MOST IMPORTANTLY, note that determining the proper payroll for a business owner is not an absolute science. It’s a subjective analysis and this diagram is simply a ‘starting point’ or a ‘guide’ for S-Corporation owners to talk about with their tax professional. Nonetheless, I have found these boundaries to be sufficiently reasonable in discussions with IRS representatives when working with clients and their payroll allocation over the past 20 years.
S-Corp Tax Abuse
The problem with this strategy is that some small-business owners abuse it by taking too little or no payroll, thus ruining it for the rest of us. Congress occasionally takes up this issue and debates the strategy because of this abuse.
Many believe that legislation limiting this strategy would be terrible for business and the economy, and as such, the Senate typically will shoot down bills that would hurt the S-Corp. In fact, there are several major advocacy groups lobbying behind the scenes helping keep the S-Corp alive and well, such as the American Institute of CPAs, the Chamber of Commerce and the National Association of Realtors. The S-Corp FICA/SE tax strategy has been around for years, and it will continue to be for many years to come.
Bottom line, the S-Corp strategy works when it is used properly and is not abused. If you are making more than $40,000 (net) in your business, could use the asset protection and you are ready to build corporate credit or better legitimize your business, an S-Corp could be a perfect fit for you! If your CPA is discouraging this strategy or claiming that your payroll needs to be so high that the savings won’t be worth it, the problem isn’t the strategy; the problem is your CPA’s definition of what is too high.
If you have a profitable business as a sole proprietor, you should be considering the S-Corp and getting a second opinion if the numbers fly in the face of the advice you’re receiving. You are the captain of your ship. Take control of your business and your tax return.
Mark J. Kohler is a CPA, Attorney, Radio Show host and author of the new book “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions” and “What Your CPA Isn’t Telling You- Life Changing Tax Strategies”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. For more information visit him at www.markjkohler.com.