If your business is still filing a Schedule C as a Sole Proprietorship to report your taxable income on your individual tax return, it may be time to consider electing to be taxed as an S Corporation. Like a Sole Proprietorship, the allure of the S-Corporation is the avoidance of double-taxation that a regular corporation (C-Corp) cannot avoid. The income from the S Corporation is also reported on your personal tax return, just like a Sole Proprietorship. Even better than a Sole Proprietorship, S Corp profits are NOT subject to that heavy 15.3% Social Security and Medicare funding Self-Employment Tax. Further, Schedule C for Sole Proprietorships is the most highly audited tax return by the IRS.
This does not mean every business should be an S-Corp. There are some very important considerations that should lead you away from S-Corp taxation.
- Don’t use an S-Corp if you will have losses financed with debt. S-Corps don’t allow an increase in basis for business loans unless the debt is directly loaned to the Company by the owner. If you borrow $500k from a bank to purchase immediately depreciable equipment, those losses may get stuck at the S-Corp level and not offset income;
- Don’t use an S-Corp if you want to allocate income on an incentive basis or anyway differently than based on ownership. S-Corps can only have one class of shares and incentive comp usually results in at least two different classes.
- Don’t use an S-Corp if you may distribute property, other than cash, from the business, such as investments, equipment, etc. Unlike a partnership, appreciated property is distributed from an S-Corp is deemed at fair market value and not considered distributed with a carryover basis. If your business is paid with cryptocurrency for instance and you wish to distribute it to the owners – sorry, you now have phantom income for the difference between the FMV and property basis.
- Don’t use an S-Corp for real estate holdings or rentals. S-Corp assets do not receive a step-up in tax basis of the underlying assets of the S-Corp upon the death of a shareholder (only the stock value of the S Corp receives the step-up). Additionally, real estate businesses are typically subject to the aforementioned issues in this post.
- S Corporation owners need to pay themselves a “reasonable salary” for the services if they are providing services to the Company. As such, payroll compliance services are needed.
In my experience, most other small to midsize businesses that don’t fall into the above listed scenarios are great fits for S-Corp taxation. S-Corps work great for…
- Any type of fee income/service business income ( such as consulting; it excludes rental property income)
- Highly profitable sole proprietors.
- There are numerous planning opportunities with the Qualified Business Income Deduction that can reduce taxable business income by 20%.
- Additionally, there are several retirement plan options available to S-Corps that don’t work nearly as well with a sole proprietorship tax structure, such as solo 401(k)’s.
- Businesses domiciled in states Implementing Entity Level Taxes, such as:
- North Carolina
Avoiding the 15.3% Self-Employment is a huge benefit to S-Corp taxation, but I want to spend the rest of this blog post going into state level entity taxes as that is the most recent law change to benefit flow through entities like S-Corps.
Our headquarters are in Annapolis, Maryland and I have many clients in both Maryland and Virginia. Both of these states recently now allow a pass-through business entity to elect to pay tax at the entity level for a Maryland or Virginia resident owner’s distributive share of income. What does that mean? It’s probably just easier to illustrate it to you, but first we need to know the problem we are trying to solve.
The 2018 Tax Cut and Jobs Act limited the state tax deduction on a personal tax return to $10,000. Even if you pay $100,000 in state income and real estate taxes, you will only get a federal income tax deduction for $10,000. For states like Maryland with an approximate 8% tax rate, this is tough for business owners and high earners to swallow.
The IRS now allows deductions for state income taxes paid by a pass-through business entities. At first, the federal tax treatment was uncertain because the entity level tax payments could allow small business owners to circumvent the $10,000 cap on itemized state income tax deductions. The IRS’s latest guidance benefits Maryland and Virginia (and select other states) business owners by electing to pay tax at the entity level.
Below is an illustration of how this state entity tax election can save the taxpayer federal tax each year that the election is in effect. Note that there are special considerations that should be discussed when there are non-resident shareholders, and, as your sworn fiduciary, we will continue to do as applicable for your financial plan.
Without State PTE Election
With State PTE Election***
Distributive Share of Taxable Income Reported on Federal Tax Return
Federal Tax Rate
Federal Income Tax Due
Tax Savings on Federal Tax Return
*** Analysis assumes a MD taxpayer paying the 8% state tax at the entity level and deducting the payment