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Tax-Saving Opportunities for “Active” S Corporation Shareholders

By Carolyn C. Quill, CPA

Two major pieces of tax reform legislation, the Patient Protection & Affordable Care Act and the American Taxpayer Relief Act of 2012 (the Acts), went into effect in 2013.  As a result of these Acts, S corporations are now a better choice for many active closely held business owners, since S corporations provide business owners with a unique opportunity to lessen their tax burdens not available to other types of entities.  Accordingly, now is the right time to revisit your choice of entity as well as reviewing your tax planning opportunities.

Effective January 1, 2013, these Acts increased employment taxes and imposed additional tax on net investment income (NII).  NII is generally defined as the sum of a taxpayer's passive income.  Passive income includes  interest, dividends, annuities, rents, royalties, capital gains, and passive income from a trade or business.  The Medicare tax on compensation and self-employment income increased .9% from 2.9% to 3.8% for high-income taxpayers ($250,000 for married taxpayers filing jointly and $200,000 for single individuals).   This increase in tax is born by the employee or self-employed individual, not the employer.  The highest individual tax rate now exceeds the corporate rate. In addition, for high-income individuals, new rules on the disallowance of itemized deductions and phase-out of personal exemptions give rise to an even higher individual effective tax rate.

A shareholder-employee’s compensation for service is subjected to employment taxes while his distributive share of the corporation’s income is not, assuming his distributions do not exceed his basis in the S corporation.  Active shareholders avoid the NII tax on the shareholder’s entire distributive share of the S corporation’s income.  Active shareholders are generally those that materially participate in the business.  Any gain or loss on the sale of S corporation shares held by an active owner is included in NII only to the extent  the gain or loss is related to a passive activity. Conversely,  a passive shareholder is subject to the NII tax on his compensation, distributive share of the corporation’s income, as well as, any gain on sale of the S corporation stock.

For active S corporation shareholders, the key to minimizing earnings subject to the additional layer of NII and employment taxes, is to separate compensation for service from the shareholder’s distributive share of corporate income.   This separation should be carefully structured while keeping the IRS' incentive to allocate income to salary rather than distributions in mind.  An S corporation shareholder should be paid a reasonable compensation to help avoid the reallocation of distributions to salary.  Unfortunately, there is no test to determine what is considered reasonable compensation.  It is determined on a case by case basis and must consider all the facts and circumstances.

For assistance in forming a new entity, re-examining your current entity classification and reviewing your tax planning opportunities, please contact our office for an appointment today.

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