While working with his clients, Emil noticed a pattern of small business owners who came to him during tax time with unorganized and inaccurate financial statements. Some of the books were kept by the clients themselves, and others by outside bookkeepers. In 2018, Emil founded Anchor Bookkeeping, an easy to use digital service, where each small business has a designated bookkeeper looking after their books and providing them monthly and yearly financial statements. Since many of our clients have small businesses (many are run as an S Corporation), we sat down with Emil to ask him common questions our clients ask regarding running a corporation.
Q: Why am I required to take a reasonable salary from my S-Corporation? A: S Corporation shareholders enjoy limited personal liability and a beneficial pass-through structure. With this tax structure, shareholder distributions from an S corporation aren’t treated as self-employment income, thus avoiding the high self-employment tax rate on their share of the income. This allows for savings on payroll taxes since such taxes are not paid on shareholder distributions. However, an S corporation shareholder performing more than minor services for the corporation is considered an employee for tax purposes, as well as a shareholder, and needs to be paid as such. The IRS is paying close attention to S corporations, and when shareholders aren’t paid a reasonable salary it’s a major red flag and the likelihood of an audit goes up drastically.
Q: How much is a reasonable salary? A: Unfortunately, there is no way to guarantee the salaries you set will square with what the IRS thinks is reasonable. But if a business owner shows a good faith effort to pay reasonable salaries, the IRS is more likely to defer to your judgment. Since a reasonable salary is a subjective number, you should have some justification for the salary you choose, and should consult with your trusted CPA to set an appropriate figure.
Q: What kind of business entity will benefit me tax wise? A: Each type of business structure has advantages and disadvantages. Some factors to look at are whether you have partners or not, your business revenue and profit, and how much liability protection you need for your business. For tax purposes, each business’ situation is different, based on their goals, and how much flexibility their business requires.
Q: Will I get the new tax 20% Pass Through Deduction? A: Flow through entities (S-Corporations, LLC’s, LLP’s and Sole Proprietors) will get the deduction if their taxable income on their personal return is below $315,000 for married filing jointly and $157,500 for all other taxpayers. In order to qualify for the deduction, it needs to be determined if your business is a ‘specified service business’, which is any business that relies on the skill or reputation of one of its owners or employees (health, law, accounting, consulting, brokers, athletics, financial services, etc.). If it is determined that your business is a specified service business, the deduction is calculated differently.
If the personal return of the owner of the specified service business has taxable income of LESS than $315k (married filing joint) or $157,500 (single), they CAN deduct 20%; If the personal return owner of the specified service business has taxable income BETWEEN $315k and $415k (married filing joint) or between $157,500 and $207,500 (single), they will get a PARTIAL DEDUCTION; If the personal return owner of the specified service business has taxable income of MORE than $415k (married filing joint) or $207,500 (single), they get NO deduction.
Q: Is there any way, to get below this threshold if you are above the limit? A: Yes! With proper tax planning, your CPA can help with a tax strategy that could bring your taxable income below the threshold where your business may qualify for the 20% pass through deduction. Tax planning is on case by case basis, but well worth looking into.