Five million small businesses operate as S corporations. And surely most of those folks know the simple trick for saving money with an S corporation. You pay a low salary and avoid payroll taxes.
Too many S corporation owners, unfortunately, do not know about all the other more advanced S corporation tax planning tricks and tactics. Thus, this month’s blog post.
Basic S Corporation Trick: Avoid Payroll Taxes
To start, however, I want to review the standard, simple S corporation trick for saving taxes. Just to make sure we’re all on the same page.
And to do this, let me give a quick example where a business owner earns $100,000. I’m going to slightly round the numbers, by the way. That’ll keep this blog post more readable.
Tip: Use our free calculator to estimate S corporation tax savings for your situation: S Corporation Tax Savings Calculator
If the business operates as a sole proprietorship or a partnership and the owner realizes $100,000 of profit. He or she pays Social Security and Medicare payroll taxes on most of the $100,000. Those taxes run roughly 14%, which means about a $14,000 payroll tax. (The actual formula might work like this: a 15.3% tax on 92.35% of the $100,000. And now you see why I’m rounding numbers. And simplifying.)
If the business instead operates as an S corporation, however, tax law allows the business owner to split the $100,000 into regular employee wages and then a shareholder distributive share. The split, by the way, needs to be fair. The resulting shareholder-employee wages amount needs to be reasonable.
But if a business owner can reasonably split the $100,000 of profit into $50,000 of wages and $50,000 of distributive share, he or she halves the payroll taxes. The savings in this case run slightly more than $7,000 a year, which is great.
Too many S corporation shareholders stop there, however. Because a bunch of other powerful, more advanced S corporation tax planning tactics exist.
Trick #1: Optimize for Section 199A Deduction with Higher Wages
A first powerful technique: some business owners pay too little in W-2 wages by focusing just on the payroll tax savings. But if a business generates Section 199A qualified business income and earns its owners a high income, the owners need wages to support a full Section 199A deduction.
The Section 199A deduction, something we’ve talked about a lot through the years (see list here), allows a taxpayer to avoid paying income taxes on the last twenty percent of her or his taxable income. If a taxpayer’s income rises above a threshold amount—roughly $200,000 for a single filer and roughly $400,000 for a married filer in 2024—the Section 199A deduction can’t exceed more than 50 percent of the W-2 wages paid by the business.
Now to be clear, you can’t arbitrarily set your wages to some amount simply to optimize your 199A deduction. You need to pay yourself a reasonable salary. But in general, if you’re losing 199A deductions because you don’t have enough wages, you want to look at bumping your wages so you’re paying out 2/7ths of your profits as wages and 5/7ths as shareholder distributions.
Example: An S corporation makes $7,000,000 in profit for its owner. The owner pays herself $500,000 in W-2 wages, and those are the only wages. This approach limits her Section 199A to just $250,000. If she can reasonably bump her wages to $2,000,000, she increases her Section 199A deduction from $250,000 to $1,000,000. That bump should save her about $280,000 in income taxes.
Trick #2: Split a Specified Service Trade or Business to Requalify for Section 199A
Another 199A gambit: many high-income S corporations lose the Section 199A deduction because some part of the operation is a specified service trade or business (SSTB). These SSTBs include most of the traditional professions (but not all), performing artists, athletes, and celebrities.
But a tip? Many entrepreneurs operate multiple trades or businesses, some of which are SSTBs, and some of which are not. Often, the entrepreneurs hold these businesses in a single S corporation entity. The problem here: combining an SSTB and a non-SSTB disqualifies the entire business for purposes of Section 199A. This leads to an obvious idea: if the business owner can split one S corporation into two S corporations, that’ll often re-qualify some of the income for the Section 199A deduction.
Example: A physician owns a clinic and earns $400,000 practicing medicine. He also provides continuing medical education services in his specialty and earns $400,000 from that. If he combines those two activities in a single S corporation, he loses the 199A deduction on 100% of the $800,000 of income in all likelihood. Practicing medicine counts as an SSTB. And if half the taxpayer’s activity is SSTB-related, that taints everything. If, however, he separates the two activities into separate trades or businesses, probably using a couple of S corporations, he can get a big $80,000 199A deduction on the second non-SSTB business of providing continuing medical education. The savings here: close to $30,000 annually.
Trick #3: Elect to Pay Pass-through-entity Tax
A quick option for shareholders living in states with income taxes.
You can probably pay the state income taxes you individually owe on your S corporation profits directly from the S corporation. To do this, you make an election to pay a pass-through entity tax. And you want to do this.
Here’s why: if you personally pay the $30,000 in state income taxes on your S corporation profits, you almost surely don’t get a federal tax deduction for the payment. (Federal tax law limits the Schedule A tax deductions for state and local taxes to $10,000.) However, if your S corporation pays the $30,000 as a pass-through-entity tax, you almost surely will get a $30,000 federal tax deduction. If your federal tax rate is, say, 24%, that tweak to your tax accounting should save you about $7,200.
Trick #4: Use Tax-free Fringe Benefits
A simple gambit: you want to load as many tax-free fringe benefits onto your S corporation tax return as you can. These fringe benefits bump your shareholder-employee compensation without bumping your payroll taxes.
Example: Suppose an entrepreneur owns an S corporation that generates $100,000 of profit but wants to pay herself $50,000. That amount might be unreasonably low. But if she provides herself with $30,000 of health insurance (which counts as wages but isn’t subject to income or payroll taxes), that $80,000 of W-2 wages and fringe benefits might rise to the level of reasonable.
Trick #5: Set up a Generous Pension for Shareholder-employees
We think most small businesses want to set up good employee pension plans for rank-and-file employees. That step, especially when small firms compete for talent, makes good sense as a business practice in many situations.
But entrepreneurs also want to think about pensions as tax planning gambits they can use to not only save taxes but build wealth outside of their equity in the business.
Example: A Simplified Employee Pension (SEP) plan lets a business owner contribute up to 25 percent of their W-2 wages. Someone who pays herself $50,000 in base wages and then $30,000 in health insurance might be able to pay a $20,000 SEP contribution. This pension plan contribution in this situation probably saves payroll taxes. (With an S corporation, the SEP contribution saves both income taxes and payroll taxes.) And it also probably increases the reasonable compensation. Someone who receives $50,000 in base W-2 wages, $30,000 in health insurance benefits, and $20,000 of pension contributions arguably enjoys a $100,000 compensation package.
But higher-contribution options exist too. Inexpensive 401(k) plans in many cases not only allow for 25 percent employer contributions but let the shareholder-employee also add elective deferrals (from their W-2 wages) that in 2024 equal $23,000 for most individuals and $30,000 for folks aged 50 or older.
In special cases, an S corporation allows a shareholder-employee to set up a defined benefit plan that might allow an even larger employer contribution. Perhaps a low to mid six-figures deduction in some situations? Again, in this case, that pension benefit should count toward the reasonable compensation requirement. And as with SEP contributions and employer matching for 401(k) plans, a large defined benefit plan contribution saves not only income taxes but payroll taxes.
Trick #6: Own Partnership Interests Through an S Corporation
A partnership cannot own an interest in an S corporation. In essence, only U.S. citizens and permanent residents, and other taxpayers very similar to U.S. citizens and permanent residents can own interests in an S corporation. But this rule gets twisted and scrambled sometimes.
For example, the rule about eligible shareholders sometimes gets rephrased (incorrectly) as saying that an S corporation cannot own an interest in a partnership. But it can. Thus, if you own partnership interests in working trades or businesses and those partnerships generate self-employment income for you, you should explore with your tax advisor the possibility of setting up an S corporation and then having your S corporation own your partnership interests. That tiered structure—owning an S corporation that owns a partnership interest—will let you harvest many of the benefits of owning an S corporation already discussed on your partnership income.
A sidebar: Partnerships provide their own tax planning benefits including the ability flexibly allocate income and deductions. Thus, combining partnerships and S corporations in a tiered structure often lets you enjoy the best of both worlds.
Trick #7: Group Compatible Activities with an S Corporation
If you own an S corporation that operates an active trade or business generating strong profits and you start a new business, you need to consider making grouping elections that combine a loss-generating activity with the profitable S corporation’s activity.
Example: If you own two activities, materially participate in the one making $500,000 a year but don’t materially participate in the one losing $300,000 a year, you can’t use the $300,000 in losses to shelter any of the $500,000 of income. However, chances are good that you can find a way to group the two activities into a single activity. And that grouping will let you use your material participation in the one business for both businesses.
Predictably, the IRS requires your grouping to follow common-sense rules. We discuss those in another blog post here: Grouping Activities to Achieve Material Participation. But the general concept? The grouping needs to be timely and reflect common sense.
Trick #8: Use the Self-rental Rules to Harvest Big Real Estate Deductions
A related trick: in theory, real estate investments should allow entrepreneurs to shelter other income. Say someone owns a business that generates $200,000 of taxable income and owns a real estate property that loses $100,000 on paper due to depreciation.
A taxpayer might think he or she can use the $100,000 loss to shelter half of the $200,000 in income. However, in many cases, tax law prevents you from doing this. A specific chunk of the law, Section 469, prevents you from taking the easy obvious deduction in most cases.
A handful of ways exist to dodge the Section 469 limitations on real estate-related losses, however. And one of the most powerful ways works for profitable S corporations. If you elect to group a self-rental property with the other active trade or business using the property, the Section 469 loss limitation rules don’t apply if you set things up right.
This gambit is a little tricky. The ownership percentages of the rental property and the S corporation need to match. Also, you need to make the grouping election when you acquire the property. But done right, you can use depreciation deductions from real estate you own and use in your business to shelter that business’s income.
One other note: normally nonresidential property results in a tiny trickle of real estate depreciation deductions over basically four decades. That doesn’t do much to help with a profitable business you’re running today. You can, however, frontload your depreciation deductions using accelerated depreciation. In some cases, you might be able to immediately deduct ten, twenty, or even thirty percent of the purchase price in the year you invest.
Trick #9: Put a “Hobby” Inside Your S Corporation
Okay, I want to be very careful here. I am not saying you can operate a hobby inside your S corporation and thereby deduct hobby losses or hobby expenses. Again, not saying that…
Furthermore, for you to deduct expenses on a business tax return, you must be engaged in the activity in pursuit of profit. That’s a requirement of a little chunk of tax law called Section 183 and popularly referred to as the “hobby losses rule.”
However, some activities you engage in for profit may look like a “hobby” or an “activity not engaged in for profit” if you operate the activity outside of an S corporation. In a worst-case scenario, you lose the deductions these activities generate. Putting the income and expenses inside your S corporation may work, however.
Example: Say you do barn design and home interiors design that reflect an owner’s interest in and love of horses and all things equine. Maybe you sell your work to horse folk who can’t normally be approached or marketed to using telephone calls, email blasts, or direct mail. But you can effectively market through personal one-on-one selling if you’re riding your own horse at dressage competitions, cross country events, or hunter jumper shows.
In this case, you very likely might lose your deductions if you conduct your horsemanship activities outside your business. But if you do all this stuff “inside” an S corporation that does barn and home design work, the deduction will probably work. (For an example of how this might work, take a peek at this Tax Advisor article: Aggregating Activities to Avoid the Hobby Loss Rules.)
Trick #10: Section 1202 Qualified Small Business Stock Inside an S Corporation
A final trick to mention: some stock in C corporations qualifies as Section 1202 Qualified Small Business Stock. The attraction of this qualification? When the stock is sold, capital gain is either partially or wholly avoided as long as the requirements are met. For stock acquired after Sept 28, 2010, the exclusion equals 100% of the gain if held more than five years. (A handful of other requirements exist too.)
Stock in an S corporation can’t “be” Section 1202 stock. But some taxpayers who own S corporations have a workaround on this. A taxpayer who owns an S corporation with a valuable activity that can be spun off into a separate C corporation can often get Section 1202 for that corporation.
We’ve got a longer discussion of how Section 1202 works here: Section 1202 Qualified Small Business Stock Exclusion. But know for now that you might be able to use the Section 1202 tax planning strategy even for some activity you start up inside an S corporation.
Example: A taxpayer does contract programming as an S corporation. A few years after starting this venture, the S corporation owner working weekends also develops a software program. The S corporation then “incorporates” a new C corporation owned by the S corporation and contributes the software program to that new C corporation. Thus, the S corporation owns a C corporation that owns and sells the software program. Assume at the point the software program is contributed to that new C corporation the software program and therefore the C corporation is worth $1,000,000. Further assume the S corporation sells the C corporation for $11,000,000 five years later. In this situation, the S corporation will treat $10,000,000 of the $11,000,000 of gain as Section 1202 qualified small business stock gain and pay zero income taxes.
A Final Comment about Advanced S Corporation Tax Planning
Your existing tax advisor probably knows about all this stuff. So, if you’ve got questions or ideas you want to run by an expert, talk to her or him. (I mention this because I see too many advertisements on social media sites where someone advertising “tax strategy consulting” suggests they know something your regular tax advisor doesn’t.)
But if you don’t have access to someone expert you can easily ask about these sorts of ideas? Sure. Go ahead and reach out to our CPA firm. Here’s how to contact us: Click here. We’d be happy to discuss working with you.