Why an S-Corporation May Be a Good Move in 2016

Why an S-Corporation May Be a Good Move in 2016

There are two major reasons why you may choose to form an S corp. First, shareholders and officers of an S corp are not personally liable for corporate debts and liabilities. Second, your share of the S corp’s net income will not be subject to self-employment tax. (SE tax is a combination of Social Security and Medicare taxes also referred to as FICA.).

Many small-business owners already take advantage of the savings that an S corp offers in regards to the SE tax. However, some tax planners continue to advise business owners to stay away from the S corp because the strategy to save on SE tax is subject to abuse by some unscrupulous business owners and sometimes comes under fire by legislators. Please don’t listen to this advice without getting a second opinion.

Bottom line, the S corp strategy works when used properly and is not abused. The majority of our legislators know this. The S corp SE tax saving strategy has been around for years, and I feel strongly that it will continue to be so for many more years to come.

Asset Protection Benefits

As with the LLC and standard corporation, asset protection is one of the major benefits of the S corp. In fact, the same protection of the corporate veil is afforded to both the S and C corp, provided they are established and maintained properly.

One of the primary advantages of incorporating your business is that you are not held personally liable for the debts or liabilities of the entity. In other words, creditors can only pursue the entity’s assets and cannot reach the your personal assets. This layer of protection which separates the entity’s liabilities from the business owner’s assets is commonly known as the “corporate veil.”

Under some circumstances, a creditor can pierce the corporate veil and reach the assets of the business owner. While the law may differ slightly from state to state, here are four major reasons why a corporate veil might be pierced:

  • Failure to properly maintain separate corporate records, minutes, and status
  • Inadequate capitalization at the time of formation
  • Not using the company name in your operations or on your documents
  • Commingling funds

These factors aren’t the only ones courts generally apply, but are certainly the most important. Essentially, the court is doing a balancing test to determine whether, in any given situation, the person or shareholder is separate from the corporation and if the corporate veil has been maintained and provides protection.

Saving on Self-Employment Tax

Second, S corps can save immensely on the dreaded SE tax. If you’re operating as a sole proprietor or an LLC and creating ordinary income from operations (i.e. sales of service or products), all of your net income will be subject to FICA/SE tax. In 2015, the tax is 15.3 percent on the first $118,500 of net income (this amount is adjusted for inflation annually), then 2.9 percent on everything above that.

However, the S corp allows its owners to take a reasonable payroll through a W-2 and take a good portion of their profit as net income under the K-1. The beauty of this strategy is that the business owner only pays SE tax on their payroll, and not on the flow-through income from the profit.

S Corporation 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 occasionnally takes up this issue and debates the strategy because of this abuse.

Many consider legislation limiting this strategy terrible for business and the economy, and typically the Senate will shoot them down. In fact, there are several major advocacy groups lobbying behind the scenes helping make this happen, 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 so for many more years to come.

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. Moreover, it’s important to maintain this procedure through proper payroll planning.

Here is a diagram that 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 $40,000 of net income and a 50% 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 net income of at least $30,000.

Payroll Matrix
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The Future of S Corporations

S corps have a far-reaching effect on our economy. According to a 2012 study by Ernst & Young, 54 percent of the private workforce in America works at a “pass-through” company such as an S corp, partnership, or LLC. Moreover, according to the S corporation Association of American, pass-through companies contribute more to the bottom line of the economy than do C corps, and the percentage of entrepreneurs choosing this type of business entity is growing.

If your CPA is discouraging this strategy or claiming that your payroll needs to be so high 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.

There have been hundreds of cases published giving examples of abuse and IRS enforcement for low payroll levels. Ninety percent of these cases are instances where the taxpayer took no salary at all! In the other cases where they take a salary, yet still fail under audit, they fall outside the guidelines I set forth in my “Payroll Matrix” above.

Some practitioners will also argue that the S corp strategy is “going away,” so why try? This makes no sense to me. Use the strategy as long as it’s available, and if Congress limits the strategy in the future, we can all modify our approaches at that point.

If you have a profitable business as a sole proprietor, your CPA or tax advisor could be costing you thousands. Do they have the same risk tolerance as you? You are the captain of your ship. Take control of your business and get a second opinion!!

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.

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