In consideration of the 80,000 plus additional IRS agents in the Biden Administration’s proposed Build Back Better Legislation, we want to remind all “S” Corporation clients of three matters important to protecting yourself from adverse tax consequences. After reading, if you have any questions or need assistance please contact your resource at BFI.
REASONABLE SHAREHOLDER SALARY:
The IRS places a HIGH priority on “S” Corporations paying a reasonable Shareholder salary.
As a Shareholder in an “S” Corporation, you are an investor in the business. Most often, you are providing services in the business and therefore you are an employee in the business as well. As an employee, the salary you receive is subject to payroll taxes (Social Security, Medicare and Unemployment Tax). As an investor, the income allocated to you after your salary is not subject to payroll taxes. The lower the Shareholder salary the bigger the savings in payroll taxes. However, the IRS is aware there are many “S” Corporations not paying a reasonable Shareholder salary in order to take advantage of the payroll tax savings.
Attempting to demonstrate a reasonable approach to determine a reasonable Shareholder salary will go a long way in avoiding issues with the IRS. A reasonable approach in determining your Shareholder salary is to ask yourself, what would a new investor in the business be willing to pay me for the services I provide to the business, and what salary would I be willing to accept for the services I provide to the business?
The biggest risk to “S” Corporations is not paying any Shareholder salary. The risk of not having a reasonable Shareholder salary could result in the IRS reclassifying Shareholder distributions to Shareholder salary. This would result in late payment penalties for not paying timely payroll taxes and penalties for failure to file payroll tax returns if the Shareholder is the only employee in the business. If there are multiple Shareholders in the business and distributions to certain Shareholders are reclassified to Shareholder salary there is a high probability this reclassification would result in disproportionate “S” Corporation distributions. In severe cases, disproportionate “S” Corporation distributions could terminate the company “S” status.
With the pending Build Back Better legislation, more than ever it is important to cover the many factors in determining a reasonable Shareholder salary.
In summary, careful consideration of reasonable Shareholder compensation should be a high priority for all “S” Corporations.
SELF-EMPLOYED HEALTH INSURANCE DEDUCTION IN AN “S” CORPORATION:
Self-employed people are allowed to deduct health insurance premiums (including dental and long-term care coverage). When you’re an “S” Corporation Shareholder with more than 2% of the company ownership who takes a Shareholder salary you’re treated the same as a self-employed individual when it comes to deducting health insurance premiums. However, this is not a “S” Corporation business deduction, it is a special personal deduction you take on your individual tax return (Form 1040). If you have Medicare coverage, you may deduct your Medicare premiums as part of this deduction.
Your deduction is limited to the amount of Shareholder salary you are paid each year by the “S” Corporation. You get the deduction whether you purchase your health insurance policy as an individual or have your “S” Corporation obtain it. However, your “S” Corporation must pay the premiums for you to get the deduction. Therefore, if you purchase your policy yourself, you must have your “S” Corporation reimburse you for the cost, Including the Medicare premiums.
The amount of insurance premiums paid by the “S” Corporation are included on the Shareholder W-2 and deducted in the “S” Corporation as officer’s compensation. This amount added to the W-2 is not subject to Social Security and Medicare taxes.
At this point you have deducted the insurance premiums as compensation on the “S” Corporation return and included it as income per your W-2 on your individual return. In other words, a wash. However, to the extent you have W-2 income from the “S” Corporation, not including the insurance premium amount, you get to deduct the insurance premiums as a self-employed health insurance deduction on your individual return (Form 1040).
We know this seems ridiculously complicated in order to get the deduction for insurance premiums paid for a 2% Shareholder, but it is the only manner in which to get the deduction. Remember, as an investor in a “S” Corporation, you are not entitled to a self-employed health insurance deduction.
NOTE: If a Shareholder hopes to get around the rule by employing a spouse and/or family member, they are out of luck. A spouse and/ or family member are also Shareholders for the purpose of deducting health insurance premiums.
LOANS TO OR FROM SHAREHOLDER:
Be aware if you have loans to or from a Shareholder.
In order to avoid unintended consequences, the loans should be evidenced by a note document with amortization, payment and interest terms included.
If you have loans to or from a Shareholder, we encourage you to have a discussion with your BFI resource to determine the best way to manage or handle loans to avoid a possible negative tax impact to your “S” Corporation and its Shareholder(s).