On a sunny spring weekend in Seattle nearly five years ago I attended a conference. In the audience was Pete Adeney, aka, Mr. Money Mustache (MMM).
MMM took to my message immediately, interrupting my presentation to inform me I was his new accountant. I took it in stride. My gift to gab exceeded my surprise.
What caught the ear of MMM was a strategy I have used for decades to save business clients money: the S corporation.
The beauty of the S corporation is that some of the profits flow through to the owner outside self employment or FICA taxes. At 15.3% for many, it is a meaningful savings.
Not everyone should use an S corporation (or LLC electing to be treated as such). Side hustles frequently do not have enough profit to make it work. Profits under $30,000 are best left as a sole proprietorship or partnership, without consideration for legal and other matters. Between $30,000 and $50,000 it is time to start running the numbers and once profits exceed $50,000, and are likely to continue to do so, you need to get serious about an S corporation.
Many factors come into play. The previous paragraph is only a suggestion and not hard and fast tax advice. I have S corporations in my office with less than $30,000 in profits and businesses with over $50,000 in profits still waiting for the S corporation to benefit them.
And now the advice is all wrong.
More than One Flavor of Corporation
Corporations come in two flavors: the regular, or C, corporation and the S corporation. Small businesses are familiar with the S corporation because it was designed for them. Profits flow to the owners because the S corporation rarely pays income taxes.
Regular corporations are generally larger due to tax issues. Most stocks listed on U.S. exchanges are C corporations.
Both flavors of corporation can be organized in one of two ways. The first is to organize as a corporation and the other is to organize an LLC and elect to be treated as a corporation for tax purposes. You can then elect S status, if desired.
The S corporation avoids double taxation on dividends paid out of profits. The drawback is that C corporations can provide more benefits to owners without restrictions. The dreaded “except for 2% shareholders” phrase in the tax code limits the advantages of the S corporation. In the past C corporations faced a higher income tax rate compared to tax rates for individuals.
The Tax Cuts and Jobs Act of 2017 (TCJA) changed all that.
Regular corporations prior to the TCJA had a graduated tax rate on profits that started at 15% and climbed to 35%. C corporations now pay a flat 21% income tax rate. Individual tax rates (the rate profits from an S corporation are taxed at as they flow to the owners) top out at 37%.
Instead of profits flowing to the owners on a K-1 annually, a regular corporation pays taxes on its income and pays dividends from the remaining profits. The dividend can be qualified, but multiple additional issues abound with dividends paid from a closely held C corporation we will not be able to address in this post. (The link is to an old article from the AICPA which is still relevant today.)
C corporation dividends are NOT deductible by the corporation, but are taxable to the recipient, hence the double taxation since the corporation already paid income tax on the profits. The corporation paid income tax on the profits at 21% and the owners pay tax again at the rate for dividends (qualified or non-qualified).
Up to this point it still looks like the S corporation is the way to go for virtually all small businesses and you would be right. However, for fringe benefit purposes, an S corporation is treated as a partnership, and a greater than 2% shareholder is treated as a partner rather than as an employee. To reiterate, this is for fringe benefit purposes only. And it makes all the difference.
No Simple Choices
S corporation owners still enjoys access to all the retirement plans of a regular corporation with some modifications. Health insurance premiums (IRC Secs. 105 and 106) are generally added to wages and then deducted on the personal return (Rev. Rul. 91-26). The same applies to group life insurance up to $50,000 (IRC Sec. 79) and meals and lodging for the employer’s convenience (IRC Sec. 119).
This is where the choice is less clear than in the past. The above fringe benefits still have value to the owner of an S corporation as long as a few hoops are jumped through. The benefits are available to C corporation owners as well, just with fewer hoops to jump through.
Numerous benefits available tax-free to employees do not apply to 2% shareholders of an S corporation. With the C corporation tax rate at a low 21% and dividends likely qualified (taxed on the personal return at the long-term capital gains (LTCG) rate), double taxes may no longer be the issue it once was.
For some individuals, the LTCG tax rate can be 0%. This stops double taxation of dividends in its tracks. Even if dividends are taxed it is at the lower LTCG rate rather than at ordinary income rates. The top LTCG rate is currently 20%, however, there is a small (on percentage terms) additional tax on higher incomes that could push the effective LTCG rate to 23.9%.
But the benefits are the real prize. How many fringe benefits you give the owners will determine if the C corporation is better for you. Some of these benefits are massive, allowing for 5-figure deductions. Something you can’t do with an S corporation.
Deducting Fringe Benefits
We will touch on the most common and valuable fringe benefits you can deduct with a C corporation as an owner where it isn’t allowed as a 2% or greater shareholder in an S corporation in most cases.
Flexible Spending Account (FSA): This is the “use-it-or-lose-it” account you might be familiar with. Employees are allowed to withhold from their wages or salary up to $2,700 (for 2019) per year for medical expenses. If married, a spouse can do the same.
The FSA does take planning. If the employer plan allows, up to $500 can be carried over to the next year OR up to a 2 1/2 month grace period allowed to use the money in the HSA.
The FSA is a salary deferral; a deduction is not allowed since it is already excluded from income.
You can use FSA funds for uninsured health costs, such as: eyeglasses and exams or a gym membership or message therapy with a doctor’s prescription.
You can read more about the FSA here.
There is also a Dependent Care Flexible Spending Account (DCFSA) where employees can elect to exclude up to $5,000 from income for dependent care expenses. The employer can also provide some or all of this amount as a tax-free fringe benefit. FICA and FUTA are also avoided.
There are several opportunities with a Dependent Care Assistance program (IRC Sec. 129) and a credit for employers covering qualified child care expenses (IRC Sec. 45F). You can read details here.
Health Reimbursement Accounts (HRA): This might be the number one reason a small business owner may choose the C over the S corporation.
Once again we have two choices. The Qualified Small Employer Health Reimbursement Arrangement (QSEHRA) and the Individual Coverage Health Reimbursement Arrangement (ICHRA). The ICHRA is available starting January 1, 2020; the QSEHRA is currently available.
The QSEHRA allows a tax-free benefit to individuals of $5,150 and $10,450 for families in 2019 for medical expenses, including insurance premiums (though the Premium Tax Credit (PTC) is reduced by the amount of the benefit, if claimed). The employer pays this benefit. The employee has nothing to report on her return with the exception of the adjustment to the PTC.
The new ICHRA has no annual cap. Yes, you can deduct a lot under the ICHRA! There are some differences, however. If you receive any benefit under an ICHRA you cannot get any Premium Tax Credit.
It should be noted that the QSEHRA and ICHRA are for employers without group health insurance. Employees with individual insurance is allowed and what these plans are designed for.
There are several considerations with HRAs. Here is a good chart comparing the two.
Employer Provided Vehicle: An S corporation can provide the same benefit, but it is cleaner and easier with a C corporation. The vehicle can be used by the employee for business or personal purposes and, depending on the facts and circumstances, may be tax-free to the employee.
There are a lot of moving parts to the employer provided vehicle. Discuss this option with your tax professional to determine if it is of value for you.
Employee Achievement Awards (EAA) (IRC Sec. 274(j): If you have a written plan it is a qualified plan. The qualified plan can offer awards up to $1,600; $400 if not a qualified plan.
The TCJA changed the rules a bit for the EAA. Cash and equivalents are not allowed: cash, gift cards, gift coupons, gift certificates, vacations, meals, lodging, event tickets, stocks, bonds or securities. Only arrangements that confer the right to select and receive tangible personal property (a watch or plaque, for example) from a limited assortment of items preselected or preapproved by the employer are allowed. (IRC Sec. 274(j)(3). The award must not appear as disguised compensation. There are additional limitations.
The Best Route
There are many more fringe benefits to consider. To keep this post brief I will punt on the other tax-free fringe benefits. It is recommended you review these issues with your tax professional as there are significant opportunities to reduce taxes with these strategies.
Now you need to determine if the S corporation is best for you. It boils down to the fringe benefits. The lower flat tax rate for C corporations are a consideration and your personal tax rate on dividends from your corporation will play a role, too.
However, the biggest determinant will be tax-free fringe benefits. And when it comes to benefits the HRA will top the list. Large deductions allowed with a C corporation can remove enough income from the taxable column to create an overall tax for the C corporation lower than the S corporation. It does take planning to determine this.
The QSEHRA is a powerful tool under the TCJA personal and corporate tax rates. The new ICHRA is something you must examine. With virtually unlimited deductions for health related expenses and insurance premiums, the ICHRA will make the C corporation more valuable to small business owners than ever before.
There is no shortcut. You have to put pencil to paper or have a tax professional do it for you. It might be worth paying a seasoned tax pro to help you determine the best route. Every step inserts additional tax considerations tax professional should be familiar with that a novice may not. Investing in your business can pay hansom rewards.
Tax are never easy. All the good ideas in this post still need a warning label.
If you are an LLC electing to be treated as an S corporation you can elect at any time to become a regular corporation (terminate the S election). However, you cannot elect to be an S corporation for at least five years, even if circumstances (or the tax code) change.
Also, if you are a C corporation with accumulated earnings that elects S status your tax return becomes much more complicated and probably more expensive to prepare. There are additional risks for an S corporation that spent any time as a C corporation; you should discuss these potential issues with a tax professional. The risks could subject the S corporation to additional taxes. Get all the facts before jumping.
Finally, in 2025 the tax code reverts back to 2017 rules for individuals if Congress doesn’t act. Corporate changes were permanent. One more thing to consider before you make a decision.
A small business should hire a competent tax professional to deal with the considerations put forth in this post. Too many variables can intercede.
This post allows you to ask good questions of your tax professional. A small investment with the taxguy should pay you back in multitudes of order compared to the fee invoiced.
Don’t accept the S corporation as the default for small businesses anymore. The C corporation might save you more money.
Print this post out and/or send a copy to your tax professional and ask if this is something that could benefit you. Pay the nice tax professional. She will earn her keep on this one and it is well worth it to you.
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