Tax Benefit of S Corp Election for Small Business Owners is Targeted

  • Posted by Michael Beauchemin on Fri, Nov 16, 2012 @ 08:19 AM

     One primary reason a business owners chooses to set up an S Corporation or an LLC with an S Corp election, is the tax treatment of distributions.  Unlike a sole proprietorship or partnership where business income is subject to self employment tax (Social Security and Medicare taxes) an S corporation owner can receive part of hisor her compensation as distributions which are not subject Social Security Tax or Medicare tax.

    This may change for many owners of S Corporations.  Currently there are two competing bills to target this beneficial tax treatment of S Corporation distributions.

    • Senate bill 2343 targets professional service businesses (health, law, engineering, architecture, actuarial, accounting, performing arts and consulting) where 75% or more of gross income is attributable to services of three or fewer shareholders. The senate bill has a minimum Adjusted Gross Income ($250,000 MFJ, $200,000 S/HH and $125,000 MFS)
    • House bill 3840 targets the same group of professional service businesses and would disqualify S Corporations where the principal asset of the business is the reputation and skill of three or fewer employees.  The house bill has no minimum Adjusted Gross Income.

    Essentially, you have two competing bills whereby they both strip targeted businesses from a primary benefit of the S Corporation i.e., receiving part of the compensation as distributions.  One bill uses a certain number of employees and the other uses shareholders (owners) as the criteria.

    The best way to illustrate how this will impact a small business owner is to take a look at an example for what taxes an owner will pay as a sole proprietor verses as an S Corporation.

    Both of these entities are commonly referred to as “flow through” entities.  This simply means that income generated from the business is reported on the owner’s personal tax return (business income “flows through” to the personal tax return).  Taxes paid on the business income for federal and state taxes are based on the owner’s personal tax rate.

    The owner of an S corporation is required by law to take a reasonable and customary salary as W2 wages while the owners of sole proprietorships cannot take any W2 wages.

    The owners of sole proprietorships will pay SE taxes (Social Security and Medicare taxes) while the owner of an S Corporation will pay the employer and employee portions of Social Security taxes and Medicare taxes on W2 wages taken.  In addition the owner of the S Corporation will also have to pay Federal Unemployment tax (FUTA) and State Unemployment tax (SUTA) on all W2 payroll wages.

    As a very simple example of how this works, assume a business owner will earn a net income from the business of $100,000.   For the sole proprietorship all the income will be subject to SE taxes.  The owner of the S Corporation will take a $60,000 salary plus $40,000 in distributions.  Because the owner of the S Corporation is the employer as well as the employee he will have to pay both the employer and employee taxes.  For convenience we totaled the employer and employee taxes the owner owes on this compensation.  Table 1 details out the S corporation owner’s tax obligation and table 2 compares the taxes of the S Corporation verses the taxes the owner will pay as a Sole proprietor.

    Table 1.  S Corporation Taxes for Owner of S Corporation ($60,000 in W2 wages and $40,000 in distributions, for a total compensation of $100,000)

    S Corporation Taxes

    Table 2. Taxes for S Corporation verses Sole Proprietorship  (Business Net income of Sole proprietorship is $100,000. Same compensation as S Corporation owner)

    S Corporation Verses Sole Proprietorship Taxes

    The owner, in this simple example would pay $5,021 less in taxes as an S Corporation than as a Sole Proprietor. In this example we used the total 2012 Social Security tax rate of 10.4% (4.2% for employees, 6.2% for employer and 10.4% Social Security SE tax).  This rate is set to expire at the end of December, 2012.  If it is not renewed the total tax rate for Social Security SE taxes and Employee and employer Social Security tax will increase to 12.4% and further increase the benefit of taking compensation as distributions.

    One final note regarding this example: The IRS requires owners’ of S Corporations take a reasonable and customary salary.  This example should not be used as basis for determining a reasonable and customary salary.  That decision is based on several factors and professional assistance from a CPA should be sought.

    To date neither bill has passed but both bills are still on the table.  If one of them does pass  owners, when selecting a business entity will have to consider this change against some other reasons for choosing the S Corporation selection such as:

    • It sets up a separate legal entity for the owner, thus providing some protection for the owner’s personal assets against law suits and other legal action taken against the business.
    • Fewer S Corporation are audited than sole proprietorships.

    An S corporation is not the best entity of choice for every business owner.  It is recommended that you seek counsel from both a CPA as well as an attorney to make sure that you are selecting the best business entity for your situation.