Mid-year tax planning helps minimize taxes for S corps

By: Paul Mueller Thursday July 10, 2014 0 comments Tags: blogs, Loveland, Tax Planning, Taxes

By Paul Mueller

Mueller and Associates CPA

As we enter the 2nd half of 2014, there are several key tax planning issues of importance for S Corporations and their owners.  Since their application will be unique in each situation, we encourage you to contact us to arrange a convenient time to discuss your specific situation. 

Reasonable Compensation - The owners of an active business operating as a S Corporation enjoy a distinct tax advantage over other types of tax entities.  Earnings that are not withdrawn as W-2 compensation escape the additional taxes for Social Security and Medicare.  For that reason, it can be tempting for S Corporation owners to take a relatively small salary, while increasing their corporate distributions of earnings.

The IRS is well aware of this "loophole" and is vigilant for egregious situations.  Using the analogy that "pigs get fat; hogs get slaughtered," we encourage all S Corporation owners to compensate themselves reasonably to mitigate the risk of a costly IRS challenge. Though "reasonable" will be different in each situation, compensation can be a most useful mechanism for paying income taxes in a fashion to minimize underpayment penalties. 

Health Insurance - Most S Corporation owners are allowed a special deduction for health insurance on the first page of their personal income tax returns.  This is referred to as the "self-employed health insurance deduction."  In 2008, the IRS issued Notice 2008-1 to provide guidance on the accounting for this deduction. Essentially, the S Corporation needs to pay the health insurance premiums directly or reimburse the owner if the premiums are paid personally. These payments are then treated as additional wages to the owner on their W-2.

If accounted for properly, the end result is a full deduction on the owner's personal income tax return, rather than treating them as an itemized medical deduction on Schedule  A, which is subject to the 10% adjusted gross income exclusion. This is certainly a deduction worth getting right! 

Accounting for Operating Losses - While S Corporations offer many tax advantages, one potential trap for the unwary has to do with the ability to deduct operating losses on the owner's personal income tax return.

The ability to deduct these losses is limited to the owner's personal investment in the S Corporation, oftentimes referred to as "basis.  In this context, basis is the sum of the amount invested for stock or capital plus amounts personally loaned to the S Corporation by the owner. This sum is annually increased by flow-through earnings that have not been withdrawn, and decreased by losses previously claimed.

For most S Corporation owners, particularly service businesses, this never becomes much of an issue. It can, however, become a challenge for businesses who experience losses and are leveraged with bank loans or other forms of third-party debt.

This debt, even if the owner has executed a personal guaranty, does not provide the owner with "basis" for claiming these losses on their personal return. Losses that exceed an owner's basis are suspended and are not currently deductible. Instead, they are carried forward to future years when they can be used to offset profits, or become deductible when the owner increases their basis.

Of particular importance is the need to manage the owner's payroll in these situations. There could rarely be a worse scenario for the owner of a S Corporation than to pay tax on W-2 compensation, when the offsetting deduction from the S Corporation is being suspended due to basis limitations.

With enough time for advance planning, a concern over inadequate basis can be addressed and dealt with so that the owner is able to  utilize these losses to minimize taxes.
Paul Mueller

About the Author: Paul Mueller

Paul Mueller is managing director of Mueller & Associates, CPA, a full service tax and accounting firm based in Loveland with an additional office in Estes Park focusing on small to medium-sized businesses, their owners and families. Their goal is to convert problems into creative solutions that result in lower taxes, improved efficiency and assist their clients towards achieving financial and business success.