How business owners may be able to reduce tax by using an S corporation

Do you conduct your business as a sole proprietorship or as a
wholly owned limited liability company (LLC)? If so, you’re subject to both
income tax and self-employment tax. There may be a way to cut your tax bill by
using an S corporation.

Self-employment tax basics

The self-employment tax is imposed on 92.35% of self-employment
income at a 12.4% rate for Social Security up to a certain maximum ($137,700
for 2020) and at a 2.9% rate for Medicare. No maximum tax limit applies to the
Medicare tax. An additional 0.9% Medicare tax is imposed on income exceeding
$250,000 for married couples ($125,000 for married persons filing separately)
and $200,000 in all other cases.

Similarly, if you conduct your business as a partnership in
which you’re a general partner, in addition to income tax you are subject to
the self-employment tax on your distributive share of the partnership’s income.
On the other hand, if you conduct your business as an S corporation, you’ll be
subject to income tax, but not self-employment tax, on your share of the S
corporation’s income.

An S corporation isn’t subject to tax at the corporate level.
Instead, the corporation’s items of income, gain, loss and deduction are passed
through to the shareholders. However, the income passed through to the
shareholder isn’t treated as self-employment income. Thus, by using an S
corporation, you may be able to avoid self-employment income tax.

Salary must be reasonable

However, be aware that the IRS requires that the S corporation
pay you reasonable compensation for your services to the business. The
compensation is treated as wages subject to employment tax (split evenly
between the corporation and the employee), which is equivalent to the
self-employment tax. If the S corporation doesn’t pay you reasonable
compensation for your services, the IRS may treat a portion of the S
corporation’s distributions to you as wages and impose Social Security taxes on
the amount it considers wages.

There’s no simple formula regarding what is considered reasonable
compensation. Presumably, reasonable compensation is the amount that unrelated
employers would pay for comparable services under similar circumstances. There
are many factors that should be taken into account in making this

Converting from a C to an S corp

There can be complications if you convert a C corporation to an
S corporation. A “built-in gains tax” may apply when appreciated assets held by
the C corporation at the time of the conversion are subsequently disposed of.
However, there may be ways to minimize its impact.

As explained above, an S corporation isn’t normally subject to
tax, but when a C corporation converts to S corporation status, the tax law
imposes a tax at the highest corporate rate (21%) on the net built-in gains of
the corporation. The idea is to prevent the use of an S election to escape tax
at the corporate level on the appreciation that occurred while the corporation
was a C corporation. This tax is imposed when the built-in gains are recognized
(in other words, when the appreciated assets are sold or otherwise disposed of)
during the five-year period after the S election takes effect (referred to as
the “recognition period”).

Consider all issues

Contact us if you’d like to discuss the factors involved in conducting
your business as an S corporation, including the built-in gains tax and how
much the business should pay you as compensation.

© 2020

Do you want to go into business for yourself?

Many people who launch small businesses start out as sole
proprietors. Here are nine tax rules and considerations involved in operating
as that entity.

1. You may qualify for the pass-through
To the extent your business generates qualified business income,
you are eligible to claim the 20% pass-through deduction, subject to
limitations. The deduction is taken “below the line,” meaning it reduces
taxable income, rather than being taken “above the line” against your gross
income. However, you can take the deduction even if you don’t itemize
deductions and instead claim the standard deduction.

2. Report income and expenses on Schedule C
of Form 1040.
The net income will be taxable to you regardless of whether you
withdraw cash from the business. Your business expenses are deductible against
gross income and not as itemized deductions. If you have losses, they will
generally be deductible against your other income, subject to special rules
related to hobby losses, passive activity losses and losses in activities in
which you weren’t “at risk.”

3. Pay self-employment taxes. For 2020,
you pay self-employment tax (Social Security and Medicare) at a 15.3% rate on
your net earnings from self-employment of up to $137,700, and Medicare tax only
at a 2.9% rate on the excess. An additional 0.9% Medicare tax (for a total of
3.8%) is imposed on self-employment income in excess of $250,000 for joint
returns; $125,000 for married taxpayers filing separate returns; and $200,000
in all other cases. Self-employment tax is imposed in addition to income tax,
but you can deduct half of your self-employment tax as an adjustment to income.

4. Make quarterly estimated tax payments. For 2019, these are due
April 15, June 15, September 15 and January 15, 2021.

5. You may be able to deduct home office
If you work from a home office, perform management or
administrative tasks there, or store product samples or inventory at home, you
may be entitled to deduct an allocable portion of some costs of maintaining
your home. And if you have a home office, you may be able to deduct expenses of
traveling from there to another work location.

6. You can deduct 100% of your health
insurance costs as a business expense.
This means your deduction
for medical care insurance won’t be subject to the rule that limits medical
expense deductions.

7. Keep complete records of your income and
Specifically, you should carefully record your expenses in
order to claim all the tax breaks to which you’re entitled. Certain expenses,
such as automobile, travel, meals, and office-at-home expenses, require special
attention because they’re subject to special recordkeeping rules or
deductibility limits.

8. If you hire employees, you need to get a
taxpayer identification number and withhold and pay employment taxes.

9. Consider establishing a qualified
retirement plan.
The advantage is that amounts contributed to the plan are
deductible at the time of the contribution and aren’t taken into income until
they’re are withdrawn. Because many qualified plans can be complex, you might
consider a SEP plan, which requires less paperwork. A SIMPLE plan is also available
to sole proprietors that offers tax advantages with fewer restrictions and
administrative requirements. If you don’t establish a retirement plan, you may
still be able to contribute to an IRA.

Seek assistance

If you want additional information regarding the tax aspects of
your new business, or if you have questions about reporting or recordkeeping
requirements, please contact us.

© 2020

Answers to your questions about 2020 individual tax limits

Right now, you may be more concerned about your 2019 tax bill than you are about your 2020 tax situation. That’s understandable because your 2019 individual tax return is due to be filed in less than three months.

However, it’s a good idea to familiarize yourself with tax-related amounts that may have changed for 2020. For example, the amount of money you can put into a 401(k) plan has increased and you may want to start making contributions as early in the year as possible because retirement plan contributions will lower your taxable income.

Note: Not all tax figures are adjusted for inflation and even if
they are, they may be unchanged or change only slightly each year due to low
inflation. In addition, some tax amounts can only change with new tax

So below are some Q&As about tax-related figures for this

How much can I contribute to an IRA for 2020?

If you’re eligible, you can contribute $6,000 a year into a
traditional or Roth IRA, up to 100% of your earned income. If you’re age 50 or
older, you can make another $1,000 “catch up” contribution. (These amounts are
the same as they were for 2019.)

I have a 401(k) plan through my job. How much
can I contribute to it?

For 2020, you can contribute up to $19,500 (up from $19,000) to
a 401(k) or 403(b) plan. You can make an additional $6,500 catch-up
contribution if you’re age 50 or older.

I sometimes hire a babysitter and a cleaning
person. Do I have to withhold and pay FICA tax on the amounts I pay them?

In 2020, the threshold when a domestic employer must withhold
and pay FICA for babysitters, house cleaners, etc. is $2,200 (up from $2,100 in

How much do I have to earn in 2020 before I
can stop paying Social Security on my salary?

The Social Security tax wage base is $137,700 for this year (up
from $132,900 last year). That means that you don’t owe Social Security tax on
amounts earned above that. (You must pay Medicare tax on all amounts that you

I didn’t qualify to itemize deductions on my
last tax return. Will I qualify for 2020?

The Tax Cuts and Jobs Act eliminated the tax benefit of
itemizing deductions for many people by increasing the standard deduction and
reducing or eliminating various deductions. For 2020, the standard deduction
amount is $24,800 for married couples filing jointly (up from $24,400). For
single filers, the amount is $12,400 (up from $12,200) and for heads of
households, it’s $18,650 (up from $18,350). So if the amount of your itemized
deductions (such as charitable gifts and mortgage interest) are less than the
applicable standard deduction amount, you won’t itemize for 2020.

How much can I give to one person without triggering
a gift tax return in 2020?

The annual gift exclusion for 2020 is $15,000 and is unchanged
from last year. This amount is only adjusted in $1,000 increments, so it
typically only increases every few years.

Your tax picture

These are only some of the tax figures that may apply to you. For more information about your tax picture, or if you have questions, don’t hesitate to contact us.

© 2020