Small business owners may choose S corporation status. As long as certain criteria are met (see the Trusted Advice column in this issue on “S Corp Criteria” for further information), the S corporation election will be recognized, and corporate income tax will be avoided. Instead, all corporate income will flow through to the shareholders, who will report that income on individual tax returns. Savvy planning can enhance S corporation tax benefits. For instance, owners may reduce selfemployment tax.
Example 1: Nate Sawyer and his wife, Vicki, own all the shares of an S corporation that Nate runs. In 2013, that company has net income of $300,000, which Nate receives as compensation. Nate will report that $300,000 as taxable income. In addition, Nate will owe Social Security tax, on wages up to the 2013 limit ($113,700), a 2.9% Medicare tax on the first $250,000, and a 3.8% Medicare tax on the last $50,000 of those earnings because a new 0.9% Medicare surtax applies starting in 2013. Suppose, though, that Nate determines that owners of comparable companies generally are paid around $140,000. He restructures his compensation, so he takes $140,000 in salary, leaving $160,000 as corporate profits not subject to Medicare tax. This will save Nate $5,090 in Medicare tax: 2.9% times $110,000 + 3.8% times $50,000. Note that the IRS insists that the salary S corporation shareholders take be reasonable. Our office can help S corporation owners set a fair compensation level and reduce the threat of adverse tax consequences.
Family tax planning may provide additional tax savings.
Example 2: Nate Sawyer’s S corporation is appraised at $2 million. The company has 2 million shares outstanding, so each share might be valued at $1. Nate can give 14,000 shares to his son, Tim, and 14,000 shares to his daughter, Alexa, this year. His wife, Vicki, makes identical gifts. The senior Sawyers will face no gift tax consequences because the annual gift tax exclusion is $14,000 in 2013. (Nate and Vicki can give away more shares, covered by the exclusion, because of valuation discounts, but this simplified example illustrates the concept.) By giving away a total of 56,000 shares this year, Nate and Vicki transfer 2.8% of the company to their children. With repeated gifts of this magnitude, the senior Sawyers can transfer 14% of their company in 5 years and 28% in 10 years and still retain control of the S corporation. If the children own 14% of the company, they’ll report 14% of corporate income on their income tax returns; as long as they are in lower tax brackets than their parents, the family will owe less income tax. Shifting ownership of shares also may result in lower estate tax in the future. S corporation earnings are considered unearned income, which means that the so-called “kiddie tax” can limit tax savings on transfers to children. Therefore, this incomeshifting strategy might have its greatest payoff after children leave school or reach age 24, when the kiddie tax won’t apply.