S corp

S Corp considerations for 2018 owners’ compensation resulting from the TCJA

 
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Posted by John Boykas, CPA

Owners of certain flow-through entities may qualify for reduced tax rates on qualified business income earned by the entities via the newly enacted Section 199A, part of the Tax Cuts and Jobs Act (TCJA).  If you operate as an S Corp, you may be able to take better advantage of these reduced tax rates simply by reviewing the compensation structure of payments to owners.  This planning technique must be considered during 2018 and will be relevant as long as Section 199A remains in effect (this provision sunsets in 2026).

Simply put                      

Section 199A allows for a 20% reduction in pass-through income to certain qualified shareholders (see below).  This is an easy way to save money.  Simply put, reducing the salary of owners will increase the net income flowing through to the shareholders, thereby lowering the tax rate; for example, if you are currently paying the top rate of 37%, you may qualify for a reduction of that percentage by 20%, resulting in a tax rate of only 29.6%.  Furthermore, the profits may not be subject to Medicare tax, resulting in an additional 2.9% savings.  As in the past, shareholders should be paid “reasonable compensation,” but this concept is not specifically defined.  Your trusted advisor should be able to determine whether you are in the lowest end of the reasonable compensation range in order to achieve the maximum tax benefit.  Of course, most people do not want to take home less money, but this can be solved by paying the reduction in salary as S Corp distributions, taking care to ensure that appropriate estimates are paid so that underpayment penalties are not incurred.

Example:  A small distributor where the owner historically receives a $400,000 salary that results in $100,000 net corporate income.  Without any planning, the owner will pay tax on the salary at normal rates but will receive a 20% reduction in the $100,000 corporate income, resulting in tax being paid on $480,000 ($400,000 salary plus 80% of $100,000).  With careful planning, we can reduce the salary to a reasonable $200,000, resulting in a net corporate income of $300,000.  The owner now pays tax on $440,000 ($200,000 salary plus 80% of $300,000).  This is a significant tax savings.

Now the details

For 2018, if the owner’s taxable income is less than the threshold amount ($315,000 for married filing jointly and $157,500 for other individuals), there are very few limitations.

However, two major limitations will be phased in once taxable income exceeds the threshold amounts, and will be fully applicable once taxable income is above $415,000 for married filing jointly and $207,500 for other individuals.  Specifically:

  • the deduction will not apply to “specified businesses,” e.g., doctors, lawyers, brokers, accountants, etc. (Architects and engineers are exempt from this limitation because they have better lobbyists); and
  • the 20% reduction will be limited to 50% of W-2 wages (or in the alternative 25% of W-2 wages plus 2.5% of certain property and equipment cost).  So, in certain situations, it may actually be beneficial to increase wages.

The takeaway             

There are many nuances and uncertainties regarding the application of Section 199A. And while the Treasury will eventually be issuing guidance, diligent business owners and their trusted tax professionals need to become familiar with them now.  Speak to your advisor sooner than later to discuss an optimal compensation target for 2018.

Self-employment tax: the other tax reform

 
iStock

iStock

 

Posted by Courtney Kopec, CPA

While the headlines parsed the effects of the Tax Cuts and Jobs Act of 2017, other important tax issues affecting the owners of pass-through entities were being scrutinized. Over the past year, the U.S. Tax Court modified self-employment (“SE”) tax guidelines to firm up the limited partner and LLC pass-through rules previously used to avoid self-employment tax on income earned by certain taxpayers.

S corporation ordinary income is not subject to SE tax

In Fleischer v Commissioner (TC Memo 2016-238), the taxpayer created an S corp entity to report non-employee compensation from a service provider contract he entered into with MassMutual as a financial services provider. The intended result was to exclude self-employment income tax because S-corp pass-through income is not subject to SE tax. The Court determined the income should have been reported on Schedule C and subject to SE tax. The Court applied two tests to determine whether the corporation was the controller of the income: first, the individual providing the services must be an employee of the corporation; and second, a contract must exist recognizing the corporation’s controlling position. The Court determined that the taxpayer, not his S corporation, had earned all the income.

A partner’s power is either general or limited, but not both

In Castigliola v Commissioner (TC Memo 2017-62), a law practice that was incorporated as a professional limited liability company by three attorneys had a compensation agreement that was reasonable based on average salaries in their area. The partners reported the guaranteed payments they received as subject to self-employment tax. However, the net profits distributed in excess of the guaranteed payments were reported as not subject to SE tax. The taxpayers argued that the guaranteed payments reflected reasonable compensation for their services and the earnings in excess were attributable to the partner’s investment and were akin to the items of income or loss of a limited partner. The Court determined that in the absence of a written operating agreement that identified a general partner, all three attorneys had equal management power that was in no way limited. None of the partners could be considered as limited and classify their additional income as limited partner income. Therefore, all three attorneys were general partners and all income was subject to SE tax.

A surgeon successfully separates out his passive activities

In Hardy v Commissioner (TC Memo 2017-16), a surgeon (Hardy) performed surgeries at a facility in which he held a 12.5% minority interest and so considered himself a limited partner. He held no management authority at the facility and his distributions were not related to his performance. Hardy reported the income as passive and, at first, also paid self-employment tax on the income. The core issue was whether Hardy properly reported the income as passive and the activities should treated as a single activity and “constitute an appropriate economic unit for the measurement of gain or loss for the purposes of Section 469.” The IRS argued that Hardy’s payment of SE tax implied that the activities were non-passive and should be grouped as a single activity. The Court rejected the IRS argument and held that Section 1.469-4(c)(2) permits a taxpayer to use any reasonable method of “applying the relevant facts and circumstances” to group activities and, therefore, the taxpayer was not liable for the SE tax. He would have been liable for SE tax and could not use the passive losses if the Court determined the activities were to be grouped as a single activity.

Tax planning considerations

The implications of the three cases presented are clear: the IRS wants to subject pass-through entity income to self-employment tax, where appropriate. The owners of S corps who do not take reasonable compensation are easy prey for IRS auditors. If you are an entrepreneurial owner of an S corporation and are not taking salary, or if you are a managing partner in a partnership entity, you should consult your CPA tax advisor to review your tax exposure under these types of situations.

Further reading

Think you know your S corp basis?

Utilizing the tax advantages of the S Corp for closely-held businesses run by self-employed shareholder-owners requires attention to some basic rules, planning, and documentation so that the transfer of money between the shareholder and corporation is reported correctly. The potential alternative is a costly lesson