S Corporation wages and planning

Your Guide to State, Local, Federal, Estate + International Taxation

Tax season is underway, and I bet I will see some S corporation shareholder W-2’s out there that missed including their health insurance in Box 1, taxable wages. Although this may be a small impact for some, whenever I see it (or don’t see it for that matter) the first thing that comes to my mind is, “What else did they miss?” S Corporations, like all tax entities, have specific tax saving techniques, but you must be proactive as we can only do so much at year-end. Here are a few things to keep in mind when it comes to S Corporation wages and planning.

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IRS requires S Corporations to pay reasonable compensation to a shareholder-employee in return for services. The IRS has the authority to reclassify payments made to shareholders from distributions, which creates additional tax from employment taxes. There are multiple factors in determining this, so be sure to check in with your tax professional.

2% Shareholder Health Insurance Premiums should be in the name of the shareholder or the company and paid or reimbursed by the S Corporation. This information needs to be reported to your payroll service at year-end on the W-2 to get an above-the-line-deduction. If not, it becomes a non-deductible expense or a distribution. If you have multiple shareholders, it can be problematic as income and distributions have a pro rata rule to abide by. Treated as a distribution will reduce your S Corp stock and cash will have to be paid to the other shareholders to make them whole, otherwise say goodbye to the S-election. It would then get picked up (hopefully if there was a footnote) on your personal return on Schedule A as an itemized deduction subject to the 7.5% AGI limitation, which you may or may not benefit from. If treated as a non-deductible expense on the S Corporation then it would reduce all shareholders’ basis in their S Corp stock (No one will like that). On your personal return you wouldn’t receive any benefit, because technically you didn’t pay for it through wages or distributions (The S corporation paid it as a non-deductible expense).

Bonus vs Distribution at Year-End is is always fun to meddle with. What generally happens, shareholders will take a bigger distribution at year-end. It saves them employment taxes and keeps qualified business income greater, and of course it is less work, right? Cash withdrawal and a journal entry, done! A bonus comes with additional out of pocket costs, such as employment and withholding taxes, so why would anyone want to do that? A bonus can eliminate underpayment penalties and bring your compensation up to a reasonable amount (audit protection), while also providing a tax deduction (Maybe QBI doesn’t apply to you). Tax withholdings reported on a W-2 are treated on your tax return as received equally throughout the year. It may be beneficial for you to pay yourself a lower wage (less withholding tax earlier in the year) throughout the year, paired with cash distributions. At year-end, reassess reasonable compensation, reclassify a portion of distributions to wages to meet reasonable compensation, while minimizing taxes based on your scenario. Pay in federal and state withholdings based on your year-end projection. The cash withholdings paid in on the reclassification are treated as received equally through the year. You’ve now covered your income tax liability, avoided an underpayment penalty and had time value of money working for you.

These are just a few S Corporation items to plan for and keep in mind through the year, but it is not an all-inclusive list. Contact your Henry+Horne tax advisor, and start working on a custom strategy that works for your scenario.

Chris Morrison, CPA