Category: S Corporation

You likely formed an S corporation to save on self-employment taxes.

If so, is your S corporation salary

• nonexistent?
• too low?
• too high?
• just right?

Getting the S corporation salary right is important. First, if it’s too low and you get caught by the IRS, you will pay not only income taxes and self-employment taxes on the too-low amount, but also both payroll and income tax penalties that can cost plenty.

Second, in most cases, the IRS is going to expand the audit to cover three years and then add the income and penalties for those three years.

Third, after being found out, you likely are now stuck with this higher salary, defeating your original purpose of saving on self-employment taxes.

Getting to the Number

The IRS did you a big favor when it released its “Reasonable Compensation Job Aid for IRS Valuation Professionals.”

The IRS states that the job aid is not an official IRS position and that it does not represent official authority. That said, the document is a huge help because it gives you some clearly defined valuation rules of the road to follow and takes away some of the gray areas.

Market Approach

The market approach to reasonable compensation compares the S corporation’s business with others and then looks at the compensation being paid by those businesses to employees who look like you, the shareholder-employee who is likely the CEO.

The question to be answered is, how much compensation would be paid for this same position, held by a nonowner in an arm’s-length employment relationship, at a similar company?

In its job aid, the IRS states that the courts favor the market approach, but because of challenges in matching employees at comparable companies, the IRS developed other approaches.

Cost Approach

The cost approach breaks your employee activities into their components, such as management, accounting, finance, marketing, advertising, engineering, purchasing, janitorial, bookkeeping, clerking, etc.

Here’s an example of how the cost approach works to support a $71,019 salary as reasonable compensation for this S corporation owner whose corporation had $3.5 million in revenue and 19 employees:

Health Insurance

The S corporation’s payment or reimbursement of health insurance for the shareholder-employee and his or her family goes on the shareholder-employee’s W-2 and counts as compensation, but it’s not subject to payroll taxes, so it fits nicely into the payroll tax savings strategy for the S corporation owner.

Pension

The S corporation’s employer contributions on behalf of the owner-employee to a defined benefit plan, simplified employee pension (SEP) plan, or 401(k) count as compensation but don’t trigger payroll taxes. Such contributions further enable the savings on payroll taxes while adding to the dollar amount that’s considered reasonable compensation.

Planning note. Your S corporation compensation determines the amount that your S corporation can contribute to your SEP or 401(k) retirement plan. The defined benefit plan likely allows the corporation to make a larger contribution on your behalf.

Section 199A Deduction

The S corporation’s net income that is passed through to you, the shareholder, can qualify for the 20 percent Section 199A tax deduction on your Form 1040.

The Payroll Protection Program (PPP) rules—they keep a-changin’.

During the past month, the Small Business Administration (SBA) issued a new set of frequently asked questions (FAQs) and a new interim final rule, which in combination create the following good news for the Payroll Protection Program (PPP):

• More forgiveness. The $20,833 cap on corporate owner-employee compensation applies to cash compensation only. It’s not an overall compensation limit as the SBA had stated in its prior interim guidance. Under this new rule, the owner-employee can add retirement benefits on top of the cash compensation, creating a new higher cap.
• Escape owner status. You are not an owner-employee if you have less than a 5 percent ownership stake in a C or an S corporation. Therefore, the cap on forgiveness for this newly defined non-owner-employee is not $20,833 but rather $46,154.

The new rules override prior guidance and have significance for PPP loan forgiveness today—and perhaps for obtaining additional loan monies retroactively (if Congress reinstates the PPP along with a new second round for businesses that suffered a big drop in revenue).

Here’s one example of how the new rules benefit John, an S corporation owner.

Example. John, the sole owner and worker, operates his business as an S corporation. His 2019 W-2 shows $140,000 in Box 1, of which $20,000 is for health insurance. In addition, the S corporation pays state unemployment taxes of $500 on John’s income and contributes $20,000 to his pension plan.

Based on the facts in the example, the corporation is eligible for up to $25,000 of PPP loan forgiveness, as follows:

• $20,833 on John’s salary (the cap), which the corporation pays to John at his regular rate in less than 10 weeks during the covered period;
• $4,167 on John’s retirement ($20,000 x 20.83%); and
• zero on the unemployment taxes because they were paid out in January, before the covered period began.

Advantage. Prior guidance limited forgiveness to $20,833. John’s S corporation gains $4,167 in additional forgiveness thanks to the new FAQs, assuming that the S corporation’s loan amount is $25,000 or more (which is possible).

The good news in the new guidance is that the corporate retirement contributions on behalf of owner-employees now count for additional forgiveness when the owner-employee has cash compensation greater than $100,000. And with the C corporation, the new guidance allows health insurance for the owner-employee.

If you want to attend a convention, seminar, or similar meeting onboard a cruise ship and deduct all your costs, you face some very special rules. But it can be done.

When you know the tax code rules, you will find an enlightened workaround that removes almost all the hassle and gives you what you want. The IRS considers all ships that sail cruise ships.

In 1982, your lawmakers were attempting to give the U.S. cruise ship industry a leg up by outlawing all cruise ship conventions, seminars, and similar meetings other than those

• that take place on a vessel registered in the United States, and
• for which all ports of call of such vessel are located in the United States or in possessions of the United States.

The 1982 law remains on the books. Lawmakers have not updated the limits for inflation. Here’s the cruise ship convention tax code rule as it existed in 1982 and as it exists today:

With respect to cruises beginning in any calendar year, not more than $2,000 of the expenses attributable to an individual attending one or more meetings may be taken into account under Section 162 . . .”

Had the $2,000 been indexed for inflation, the 2019 amount would be a reasonable $5,431, and that would likely encourage more 2019 U.S. cruise ship convention-type travel.

The $2,000 is pretty skimpy when you consider that the expenses include

• the cost of air or other travel to get to and from the cruise ship port;
• the cost of the cruise; and
• the cost of the convention, seminar, or similar meeting.

Bigger, Better Deductions with Less Hassle

This is a way you can avoid the $2,000 limit, take the cruise you want, and likely deduct all your costs. And this does not have to involve a U.S. ship. Any ship from any country works.

Here’s the strategy. You take the cruise ship to a convention, seminar, or meeting that’s held

• on land, say at a hotel, and
• in the tax-law-defined North American area.

When you meet the two easy requirements above, you deduct (a) the full cost of getting to and from the location; (b) the full cost of the convention, seminar, or similar meeting; and (c) likely the full cost of the cruise if your onboard ship expenses are less than the 2019 daily luxury water limits.

Using the 2019 luxury water limits, if your average daily cost of the cruise is $692 or less, you can use this strategy to deduct all cruise ship costs to travel to and from the seminar.

It’s common to consider making your S corporation (versus yourself) a partner in your partnership: it saves you self-employment taxes.

Does this affect your Section 199A deduction? It does.

Guaranteed payments are not qualified business income (QBI) for the Section 199A deduction. The non-QBI guaranteed payment rule applies whether the partner receives the payment as an individual or as pass-through income from an S corporation.

Your only options to claw back your Section 199A deduction with the S corporation as a partner are to reduce or eliminate the partnership’s guaranteed payments and then take the income pro rata based on ownership percentage, or to use a special allocation of partnership tax items.

Keep the S corporation self-employment tax savings in mind when considering your partnership activity. Often the self-employment tax savings can make the S-corporation-as-a-partner strategy well worth it.

If you own more than 2 percent of an S corporation, you have to do three things to claim a deduction for your health insurance:

1. You must get the cost of the insurance on the S corporation’s books.
2. Your S corporation must include the health insurance premiums on your W-2 form.
3. You must (if eligible) claim the health insurance deduction as an above-the-line deduction on Form 1040.

The three-step health-insurance procedure also applies under attribution rules (and this could be a surprise) to your spouse, children, grandchildren, and parents if they work for your S corporation, even if they don’t own a single share of S corporation stock directly.

You need to get this S corporation health-insurance thing right. Without the W-2 treatment, the S corporation does not get a tax deduction.

With the correct W-2 treatment, the more than 2 percent shareholder who finds the health insurance premiums on his or her W-2 can claim the self-employed health insurance deduction on Form 1040, provided he or she is not eligible for employer-subsidized health insurance through another job or a spouse’s job.