Subchapter S corporations can produce big tax savings for some small business entrepreneurs. For one thing, by making the election to be treated as an S corporation, the business pay no corporate income taxes. And working entrepreneurs often minimize their payroll taxes (Social Security and Medicare) by using the S corp option.
But the S corporation tax classification--a classification available to both regular corporations and limited liability companies--creates some problems when the economy sinks into a recession. If you own or operate an S corporation, therefore, you'll need to take the following precautions in order to continue reaping a healthy harvest of tax savings.
Precaution #1: Don't Overcompensate Shareholder-employees
A first, obvious tip regarding S corporations in years when profits are down: You often don't benefit by paying shareholder-employees enough to trigger business loss inside the S corp.
Now understand--you do need to pay shareholder-employees reasonable compensation. Employees logically still get paid even when their corporate employer falls on hard times. But what you don't want to do is put money into the corporation just so you can take it back out again as a salary. This round-trip transaction doesn't cost you income taxes. But the transaction does cost you payroll taxes. In other words, if you put $100,000 into your S corporation so you can pay yourself $100,000 of salary, just moving the money around this way creates roughly a $15,000 payroll tax bill. Ouch.
Precaution #2: Protect the Self-employed Health Insurance and Pension Deductions
Tough times may mean you want to or need to cut shareholder-employee compensation. But before you get too aggressive, remember that some of your business and personal deductions depend on you enjoying earned income.
To receive the self-employed health insurance deduction, for example, you do need employee wages at least equal to the health insurance deduction. And to get retirement savings deductions, you also need employee wages.
Accordingly, even in a tough economy where your S corp doesn't make much money or even loses money, you may still want to pay yourself modest wages--even if paying those wages means contributing money to the corporation.
Precaution #3: Take Care with the Sec. 179 Depreciation Write-off
Small businesses commonly don't depreciate their fixed assets: equipment, furniture, machinery and so forth. In 2009, for example, the typical small business can expense (immediately write off) up to $250,000 of fixed assets instead of having to depreciate this stuff over three, five or seven years.
This immediate write-off is called a Section 179 election because Section 179 of the Internal Revenue Code authorizes and spells out the rules for taking the write-off. Section 179 elections provide a wonderful tax deduction, but there's a gotcha. You can only take a Section 179 election if the business entity shows a profit. Unfortunately, you can't employ a Section 179 writeoff to trigger or enlarge a business's operating loss.
In profitable years, this limitation doesn't matter. In a tough economy where the business loses money, however, the limitation may prevent use of the writeoff. And note: Even if your S corp venture suffers a net operating loss, you might owe income taxes due your spouse's earned income or outside investments.
Precaution #4: Monitor Shareholder Basis in S Corp Stock (and Debt)
One other quick warning: When an S corporation shows a loss--something that's likely to happen in a recession--S corporation shareholders can often use that loss as a personal tax deduction on their federal and state tax returns.
However, in order to use an S corporation loss as a deduction on the shareholder's personal return, the shareholder needs basis in their S corporation stock and (if applicable) in S corporation debt.
In a nutshell, the basis limitation rule says that only losses paid for out of a shareholder's personally-made investments or loans count as tax deductions. If the money that shows up as being "lost" comes from some other shareholder or some outside lender (like the bank) the loss deduction may be delayed into the future.
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Seattle tax accountant and author Stephen L. Nelson is the author of a series of downloadable do-it-yourself S corporation ebooks including titles about starting a
Arizona S corporation and starting a
Washington state S corporation.
