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Do you own an S corporation?
And do you want to pay less tax this year?
If so, read this article to learn about strategies for avoiding or deferring taxes on your S corporation income.
What are S corporation tax planning strategies?
The overarching goal of tax planning is to minimize your total tax liability across all tax years.
Tax planning starts by thinking proactively about your financial situation and pulling the various levers that influence the amount of tax you’ll pay.
As an S corporation owner, you can minimize taxable income on your personal tax return by using tax planning strategies that avoid, defer, or accelerate taxable income and deductions related to your business.
Avoidance strategies take advantage of existing tax laws in a clever but compliant way to reduce the taxpayer’s taxable income.
Acceleration and deferral strategies shift taxable income between tax years with the goal of paying less tax in one year as opposed to the other year.
The strategies described below will provide inspiration for how you can proactively manage your business finances to pay less tax on your personal tax return.
Review owner compensation
As an S corporation owner, if you take money out of your business, these distributions generally must be treated as taxable wage compensation to the extent they constitute “reasonable compensation” for services you provide to the S corporation.
This means that you should establish a salary that’s “reasonable” in consideration of your various roles, responsibilities, and other factors established by the IRS.
Reasons to decrease owner compensation
Why must your compensation be reasonable? It’s because the IRS doesn’t want you to avoid contributing to the Social Security, Medicare, & unemployment insurance systems.
The lower your salary is, the less employment taxes you’ll pay.
The goal of this strategy is to pay yourself a salary that qualifies as “reasonable,” but not more than that amount.
Reasonableness is of course a subjective measure. To use this strategy in a compliant way, you’d want to use a variation of what the IRS calls the “cost” approach.
Using the cost approach, first summarize the tasks that you perform for your business and condense these tasks into roles that you might hire to replace yourself.
Then allocate a weight to each role according to the time you spend in that role (e.g. 25% of your total time is spent as an administrative assistant or marketing manager).
Research what other businesses are paying for these roles. Multiply the average salary by the weight you determined in the previous step. Do this for each role and sum the amounts. The result will be an approximation of “reasonable” compensation.
If the result is less than what you currently pay yourself, consider adjusting your salary downward for the upcoming tax year. You’ll pay less employment taxes which might result in less tax paid overall.
Bear in mind, there’s no rule that you must pay yourself a salary. if you don’t intend to take money out of your S corporation, then you don’t need to compensate yourself at all. You’d only use this strategy if you’re taking distributions from your S corporation.
Reasons to increase owner compensation
Paying yourself as little salary as possible doesn’t always result in less taxes paid overall.
Increasing your compensation as an S corporation owner might yield a greater tax benefit than decreasing it would yield. This is due to the Section 199A or Qualified Business Income (QBI) deduction.
Your QBI deduction is generally 20% of net business income from all businesses reported on your personal tax return. But, above certain income thresholds (see “Who Can Take the Deduction”), your QBI deduction is limited by the gross amount of compensation that your businesses, in aggregate, pay to their employees.
If your taxable income exceeds these thresholds, you can maximize the QBI deduction by increasing salaries to avoid the W-2 wage limitation paid by your S corporation.
The exact math is complicated, but a rough back-of-the-napkin calculation can give you an idea of where your QBI deduction stands.
Above the income thresholds referenced above, your QBI deduction is the lesser of 20% of net S corporation income or 50% of salaries paid by your S corporation. So, if your salary is lower than 20% of the S corporation’s income, there’s a good chance that your QBI deduction will be limited.
At year-end, if this’ll be the case, consider increasing total compensation paid by your business such that 50% of wages will equal 20% of net business income, in consideration of the decreases that compensation increases will have on net business income.
Bear in mind that the actual math is more complicated because the wage limitation is phased in between certain income thresholds.
The math is also different if your S corporation is a “Specified Service Trade or Business” (see “SSTBs excluded from your qualified trades or businesses”). Above a certain income threshold, SSTBs aren’t eligible for the QBI deduction at all. So this strategy wouldn’t apply.
An experienced tax planner can help you optimize the exact salary increment in consideration of the phase-in income ranges, “reasonableness,” and other factors. The cost of tax planning could be far less than the tax savings.
Of course, by increasing W-2 compensation you’re also increasing employment taxes. If done correctly, the income tax savings yielded by a higher QBI deduction will more than offset the incremental cost of employment taxes.
As I’ll discuss later, Health Savings Account and Solo 401(k) contributions made through payroll deductions aren’t subject to employment taxes. This makes contributing to an HSA or a Solo 401(k) through payroll effective ways to increase your compensation for purposes of optimizing your QBI deduction without increasing employment taxes.
Aggregate business activities to maximize QBI deduction
If you have more than one business or S corporation, consider aggregating these businesses for purposes of optimizing your QBI deduction. The salaries and wages paid by one business can be used to avoid the wage limitation that might otherwise apply to another business (see discussion above).
For example, suppose one of your businesses paid $0 in wages and earned $250k in profit. The QBI deduction associated with this business would be $0 due to the wage limitation.
Suppose you also have a similar business that earned $500k in profit and paid $250k in wages. By aggregating your businesses, you’d group the wages paid by this business to your other business and avoid the QBI wage limitation.
The aggregation rules are strict. You’d need to confirm that the two businesses are highly similar and share “centralized business elements” such as personnel, accounting, legal, etc.
This strategy would be used on your personal tax return. Your tax preparer can advise you on whether this strategy would be useful in optimizing your QBI deduction.
Contribute to a retirement savings plan
S corporation owners can contribute to a retirement savings plan through their business. These contributions are deductible for the business and, since S corporation income is reported on your personal tax return, the deductible contributions reduce the amount of tax you’ll pay.
As an S corporation owner, there are two plans in particular that you should consider:
- Solo 401(k);
- SEP IRA.
You can also contribute to a traditional IRA or Roth IRA, but at certain income levels you’d be subject to phase outs and your maximum allowable contribution maximums are usually smaller.
If you’re just starting out, contributing to a Traditional or Roth IRA might make sense, since these accounts are simple to maintain and the annual contribution maximums could be comparable to a SEP or Solo 401(k).
The Solo 401(k)
The Solo 401(k) is usually the most attractive choice for S corporation owners because contributions can be made through withholdings from your salary. This typically results in a higher annual maximum contribution as compared to the SEP IRA.
You can designate Solo 401(k) contributions made through payroll deductions as after-tax contributions if the contributions are made to a Roth account. SEP IRA contributions are always made pre-tax, so the Roth option isn’t available through your S corporation.
Roth contributions are generally more favorable to younger taxpayers (since earnings accumulate tax-free) or to older taxpayers who expect their marginal tax rate to be higher in retirement.
You can also contribute to a Solo 401(k) account in conjunction with the QBI optimization strategy described above. Under this strategy, you’d run a bonus payroll at year-end to increase your QBI deduction benefit, but you’d also withhold an amount from the bonus pay run equal to your Solo 401(k) contribution for the year.
Unfortunately, if your business has employees other than you, then you wouldn’t be eligible to contribute to a Solo 401(k). Consider instead the SEP IRA or SIMPLE IRA.
The SEP IRA
Contributing to a SEP IRA is another attractive choice for S corporation owners who want to pay less tax in the current year and also save for retirement.
Like Solo 401(k) contributions, SEP IRA contributions are deductible to the business and generally offer higher annual maximum contribution amounts than contributing to a Traditional IRA would allow.
SEP IRA contributions, unlike Solo 401(k) contributions, are allowed even if your S corporation has employees other than you. To be IRS-compliant, you’d need to contribute an equal amount for each employee as a percentage of their gross compensation.
I’d recommend contributing to a SEP IRA if you’re earning too much to contribute to a Traditional or Roth IRA and your business has employees, but you still want to save for retirement this year.
SEP IRA contributions can be made by your business until April 15th of the following year. Solo 401(k) contributions, however, must be made during the same tax year.
Reimburse owners for out-of-pocket health expenses
S corporations can deduct some health-related expenses incurred by its owners. The deduction reduces taxable income on the S corporation’s tax return and results in less tax paid by the business owners.
Eligible health expenses include:
- Health insurance premiums;
- Health Savings Account (HSA) contributions.
To be deductible, these expenses must be reported in Box 1 of your W-2. You’d report the Box 1 amount as income and as a deduction on your personal tax return and the business would deduct the amount as officer compensation.
However, this compensation wouldn’t be subject to employment taxes, which makes this an effective strategy for paying yourself “reasonable compensation” without paying additional employment taxes on the salary increase.
Health insurance premiums
If you own 2% or more of an S corporation, you might be eligible for the Self-Employed Health Insurance (SEHI) deduction if all of the following are true:
- The insurance plan is either in the S corporation’s name or in your name;
- The S corporation pays the health insurance premiums directly or reimburses you for the premiums;
- The amounts paid or reimbursed are reported on Box 1 of your W-2;
- You aren’t eligible to participate in another employer’s health insurance plan (either yours or your spouse’s).
You’d take this deduction and report the wage income on your personal tax return. Your S corporation treats the health insurance premiums paid or reimbursed as deductible compensation.
The premiums get deducted twice (by you and the S corporation) and taxed only once (on your tax return). Plus, this income isn’t subject to additional employment taxes (i.e. Social Security & Medicare).
Health Savings Accounts (HSAs)
Contributions to a Health Savings Account are deductible on your personal tax return.
If you’re an S corporation owner, your business can reimburse you for HSA contributions and deduct the reimbursements as owner compensation.
The reimbursements would be reported on Box 1 of your personal tax return. You’d report this amount as taxable wage income and also take the offsetting deduction for HSA contributions.
So, like the SEHI deduction, the reimbursement gets deducted twice (by you & the S corporation) but taxed only once (on your personal tax return).
Set up an accountable plan for out-of-pocket expenses
Distributions that you take from your S corporation generally have no impact on the taxable income reported by your S corporation. However, S corporation owners can take a deductible distribution from their business if the distribution qualifies as an “accountable plan” reimbursement.
Reimbursements for out-of-pocket expenses decrease the taxable income reported on the S corporation tax return. The decrease in taxable income flows through to your personal tax return, which results in less tax paid by you.
To be deductible, reimbursements from your S corporation must be made under what the IRS calls an “accountable plan.”
An accountable plan is an IRS-approved method for making tax-free reimbursements to employees of an S corporation, partnership, or corporation for expenses incurred on behalf of their employer.
Your accountable plan doesn’t need explicit approval from the IRS, it just needs to follow the established accountable plan guidelines. Think of it as a formal policy that you have in place for employees (including yourself) that mirrors the IRS guidelines.
Establishing an accountable plan allows you to take deductions for a home office, mileage, business travel, a personal cell phone, client meals, HSA contributions, and other business expenses paid out-of-pocket.
If you’ve ever operated as a sole proprietorship, you might have taken a deduction for these expenses on Schedule C or other schedule of your personal tax return.
If your business is an S corporation, you can’t take a deduction on your personal tax return for out-of-pocket expenses. The business must take the deduction on its separate tax return as an accountable plan reimbursement.
Employ your children to shift income
If you have a child who’s willing and able to work, consider letting them work for your S corporation. Doing so will shift business income from your tax return onto your child’s tax return, who’s likely subject to a lower tax rate.
Your business would deduct the wages paid to your child, which reduces taxable business income that flows through to your personal tax return. The result is less tax paid by you.
Your children would get a W-2 at year-end that reports the wages your S corporation paid them. They’d then file a tax return, if taxes were withheld, to get a tax refund. If their wages are below the federal standard deduction amount then they’d owe no federal or state income taxes.
Your business and your child will pay Social Security, Medicare, and unemployment taxes on their wages. But the cost of these taxes is typically less than the income taxes you would have paid on the business income.
In addition to the tax savings, your child can use their earned wages to fund a retirement account, such as a Traditional or Roth IRA. The wages could later be withdrawn to pay for higher education expenses without penalty.
You must pay them a reasonable salary based on the amount of work they do and what others would normally be paid in that position. The IRS will ask about the work your children perform in the event of an audit.
Also, be mindful of labor laws in your state before pursuing this strategy.
Accelerate deductions & defer revenues to shift income
A dollar saved now is better than a dollar saved later, in most cases.
With this in mind, accelerating tax deductions to the current year is preferable to taking the same deduction next year.
The opposite is true for revenues. Deferring revenues to the following year is preferable, from a tax standpoint, to recognizing revenue in the current year, since it delays taxes paid by an entire year.
Both tactics reduce taxable income for the current year and reduce taxes paid.
In certain cases the reverse of this strategy might yield greater tax savings. Such cases would include years in which you expect your tax rate to be higher next year or if you’d like to utilize NOLs in the current year.
Here are a few ways to implement this strategy.
Change your S corporation’s accounting method
The accounting method your S corporation uses on its tax return will impact the amount of tax you’ll pay on your personal tax return. “Accounting method” refers to how your business reports income and deductions on its tax return.
As a small business, your accounting method will either be on a cash or accrual basis.
On a cash basis method, your business would report income when cash is received and deductions when cash leaves the bank account.
Under the accrual basis method, your business would report income when earned (or invoiced) and deductions when accrued (when billed).
Most S corporation owners will benefit from using the cash basis method.
You can confirm your S corporation’s accounting method by looking at its most recently filed tax return. Check Line 1 of Schedule B on page 2 of Form 1120-S.
This strategy is useful for S corporations impacted by delays in cash flow. If there’s significant lead time between when you bill customers and when you collect payment, consider reporting under the cash basis method as opposed to the accrual basis method.
Buy equipment now to accelerate depreciation
Assets with a useful life greater than 1 year must be depreciated. This means that you can’t deduct the cost of such assets in the year that you purchased them. The deduction is taken over the course of a few years.
However, some assets might be eligible for accelerated depreciation.
By using accelerated depreciation methods, you can deduct the full cost of an asset in the year it was purchased. This reduces taxable income in the year of the purchase, which reduces the amount of tax that you’ll pay.
Accelerated depreciation methods are Section 179 depreciation or bonus depreciation. Each method has unique rules so it’s important to understand these rules before making a large purchase.
In general, assets such as equipment, computers, furniture, and others like it will qualify for accelerated depreciation.
This strategy is useful for S corporation owners who intend to purchase an asset in the near future. By purchasing the asset this year, instead of next year, you’re accelerating the deduction to the current year which reduces your taxable income now.
Prepay annual software subscriptions
Your S corporation probably uses some kind of software and it probably pays for this software on a monthly basis.
Software can sometimes be purchased as an annual subscription in addition to a monthly subscription. Annual subscriptions might even qualify for a discount.
By prepaying software costs, you’re accelerating deductions into the current year, which reduces taxable income and minimizes the tax you’ll pay this year.
To use this strategy, review the software used by your business and identify good candidates for prepaying the annual subscription.
Good candidates for this strategy include software that’s reliable, that you intend to use for the next 12 months, and that offers a discount for annual prepayments.
Bear in mind that you can only deduct prepayments of software if the subscription period is 12 months or less.
Deduct state income taxes with a PTE tax election
As you probably know, S corporations don’t pay income taxes. Income is passed to the S corporation’s owners who pay the associated income taxes on their personal tax returns.
Some states assess a franchise tax at the S corporation level, but this is separate tax.
Some S corporations will pay income taxes on behalf of their owners and allocate the taxes to each shareholder according to their ownership percentage. This payment is not deductible to the S corporation and must be reported as a distribution.
However, the “pass-through entity tax” (PTET) election is a relatively new tax strategy that allows S corporations to pay state income taxes and deduct the payment on the S corporation’s tax return.
Using this strategy, the S corporation would taxes at a rate set by each state. The S corporation deducts state PTE taxes paid on its federal tax return, which reduces the taxable income that’s passed through to the business owners.
In addition to the entity-level deduction, the business owner receives a credit for taxes paid by the business entity. The credit is taken on the business owner’s state income tax return.
You can make a PTE tax election with your state tax authorities. The process varies by state, so check your state tax authority’s website to determine the exact process.
Be aware that this strategy may not always result in tax savings, especially for nonresident S corporation owners. Study your state’s PTET rules carefully before making this election.
Dispose of your interest in an S corporation to deduct passive activity losses
An S corporation’s owners might have varying levels of involvement with the business. Some owners might actively participate while others might passively participate as investors or advisors.
If you’re a passive S corporation owner, you aren’t eligible to deduct losses from the S corporation. Instead, you must carry forward losses indefinitely to future tax years to offset future income.
The exception to this rule is when you dispose of your interest in the S corporation. As a passive owner, you may deduct passive losses in the year that you dispose of your interest in the S corporation.
The suspended passive losses could potentially offset income from other S corporations that you actively participate in and other income.
Consider this strategy if you’re carrying forward passive losses on your tax return. Of course, talk to a tax adviser before pursuing this strategy as there might be other factors to consider.
Have questions?
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