Practitioner’s Tax Action Bulletin® Advisory
Fall is the time for tax planning and advisory services. Tax practitioners should have a post-busy season understanding of their client’s financial position and be able to identify clients that might benefit from reporting and filing their business operations as an S Corp. But at what point do the tax savings of S Corp status outweigh the administrative burdens and tax compliance associated with S Corp filings and which clients are ideal for S Corp conversions?
Target Clients
The ideal target clients to benefit from performing an S Corp conversion tax saving analysis would be individuals who make a significant amount of net income from business operations and file the activity on Schedule C of their Form 1040 as sole proprietors or Single-member LLCs (SMLLCs).
Significant net income is a subjective figure, however, as a rule of thumb the tax savings for filing as an S Corp, as opposed to a sole proprietor or single-member LLC, considering the additional work and fees involved, is best when net income is a minimum of $50,000/year.
The analysis will consist of calculating the overall tax savings of filing on Form 1040, Schedule C vs. as an S Corp on Form 1120-S, primarily based on the key advantages of S Corp status. The cost-benefit analysis beyond tax savings is the administrative time spent preparing additional filings, as well as the time spent discussing and training your client on how to operate as an S Corp. If the tax savings makes sense, the client will eventually get the hang of it and see the long-term cumulative benefits of making this election.
Benefits of Filing as an S Corp
S Corps aren’t subject to self-employment taxes like sole proprietors and SMLLCs. The entire net income from operating as a sole proprietor, LLC or partnership is subject to self-employment tax. Whereas the flow through S Corp income reported annually to individual shareholders on schedule K-1, and included on their individual 1040, is not subject to self-employment tax. The benefit of not paying self-employment tax needs to be balanced with the new requirement to pay Social Security and Medicare taxes on wages to S Corp owners. But with the proper analysis and planning, avoiding self-employment tax is easily one of the biggest tax savings available.
S Corp distributions to shareholders are tax-free, to the extent the distribution is a return of capital. This is of course dependent on many factors, such as the net income of the company, wages paid, remaining equity in the company, and the long-term and short-term cash flow needs of the company and owner. There are also important boundaries to tax-free distributions like the possibility of triggering distributions in excess of basis (resulting in capital gain tax treatment) and paying owners reasonable compensation.
Burdens to Consider as an S Corp
S Corp Owners must be paid “reasonable” compensation. Owners must pay themselves reasonable compensation and must withhold Social Security and Medicare taxes on wages. The IRS requires that the salary your client pays themselves be reasonable and comparable to what other businesses would pay for similar services. The IRS has many factors you can consider when determining what “reasonable compensation” is, like the nature of the services performed, amount of time and effort devoted to the business and the company’s financial condition. If the IRS determines that the salary is too low, they may reclassify any distributions (if made) as salary, exposing your client to additional taxes and penalties.
Payroll Tax and Unemployment Insurance Compliance. The S Corp will be required to file regular payroll tax returns for the owner and any other employees, which requires additional bookkeeping, tax estimates, and remittance of payroll taxes. Where there are employees, there is also federal and state unemployment insurance filing and payment requirements. This is an opportunity for the tax practitioner to provide these additional services.
Cost/Benefit Analysis
Administrative and Compliance Costs are Business Deductions. The additional administrative and compliance fees have the advantage of being ordinary and necessary business expenses which will reduce the client’s tax burden.
Opportunity for Retirement Plans and Contribution Deductions. Opportunities for retirement plan related tax deductions open when operating as an S Corp. The client is now both the employer and employee, providing opportunities for substantial employee and matching employer contributions to retirement plans such as a Solo 401(k) plan.
Qualified Business Income Deductions (QBID) for S Corps. Although the QBID deduction is currently set to expire after 2025 and is currently available for individuals with flow through income from sole proprietors, LLCs, partnerships, and S Corps, the deduction is subject to wage limitations. The fact that the S Corp pays W-2 wages may provide an opportunity for larger QBID deductions than would otherwise be available, especially where the business doesn’t have significant qualified property. In the right scenario, for high income taxpayers, larger QBID tax deductions in 2025 may just be the carrot needed to entice your clients into electing S Corp status.
Conclusion
Using Thomson Reuters Planner CS to Compare the S Corp Advantage. Given the number of factors that need to be considered in this analysis, it may seem a daunting task. Thomson Reuters provides a planning tool for tax practitioners that assists in forecasting the cost/benefit analysis of converting from a sole proprietor or SMLLC to an S Corp. Become that trusted advisor by engaging with your client for this tax planning opportunity!
Editor’s note: The full article presented above is available in the Practitioner’s Tax Action Bulletin, as Tax Action Memo (TAM -2276), Issue 12, first published June 18, 2024, along with other valuable tax practitioner articles. Contact our sales team to receive Checkpoint’s bi-monthly Practitioner’s Tax Action Bulletin — available in print and online — or to add Thomson Reuters Planner CS to your advisory toolkit.
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