S-Corp - taking the plunge

[Rich]

All of my business clients are sole props, but there are a couple where it appears to make sense to do S-Corp. Never prepared S-Corp return. Is it as intimidating as it seems? Also, one area I keep getting hung up on - if it's a service oriented business with little to no basis and owner (100% shareholder) takes distributions from net income, where should those distributions flow to? There's salary (line 7 1120-S), the net income (line 21 1120-S which flows to line 1 of K-1). So client is avoiding SE tax on all income, only paying ordinary tax rates on everything. Any net income not distributed during calendar year would build basis and distributions from basis would get cap gains rate in future? Wow, any of you willing to read all this and comment, I can't begin to thank you enough!!

[Uncle Sam]

You need to learn about S Corporations and Reasonable Salaries of Officers - you're looking for trouble if you don't.
Distributions don't get deducted on the return - they are a reduction of Accumulated Adjustments Account. Distributions in excess of basis are taxable income.
There are IRS penalties for living off of distributions and avoiding payroll taxes.
In addition your client is depriving himself of the corporate tax benefits such as health insurance, pension contributions and cheating himself of building up Social Security benefits for future years etc by NOT taking salary.
And if it's a service business - you need to determine if he is subject to the Specified Service Trade or Business for calculation of the QBI deduction.

[TAXNJ]

If you look at The TaxBook Tab 19 “S Corporations” - it provides advantages and disadvantages and examples

[TaxGuyBill]

if it's a service oriented business with little to no basis and owner (100% shareholder) takes distributions from net income,

So client is avoiding SE tax on all income

As a service business where the owners/shareholder/employee does all of the work, MOST (or possibly even all) of the profits would be for "reasonable compensation", not distributions. Salary/wages for the shareholder/owner/employer are subject to Social Security and Medicare taxes (and the associated employer forms/fillings to be filed). So for the wage part of it, there is no savings; the SE tax just changes to FICA tax. Actually, it will cost them MORE because they are subject to Federal unemployment (and possibly State unemployment, Worker's Comp, or other State requirements).

If the business has other people working for it (employees or contractors), then salary/wages can be a smaller portion of the profits, and more would be shifted to Distributions (which save Social Security and Medicare tax).

There CAN be potential savings for the compensation due to health insurance. That is part of "compensation", but unlike a Schedule C, the health insurance can avoid Social Security and Medicare taxes. If health insurance is not part of the situation (for example, they already have health insurance through another employer), in my opinion it is probably going to cost the taxpayer MORE money by paying you for all of the payroll related work. In situations where the owner does all of the work, in my opinion large health insurance premiums are the only reason to POSSIBLY shift to a S-corporation because that is the primary way of reducing Social Security and Medicare taxes.

If their total income is under the QBI threshold, their QBI deduction will likely be significantly reduced as well.


The rest of profit ends up on Line 1 of the K-1 and avoids Social Security and Medicare taxes. But as I mentioned before, if the owner is doing all of the work in a service-business, this amount will likely be rather small because most of the profits are wages (payments for the work performed). Because this money has already been taxed, Distributions are NOT taxed because the taxpayer has already paid tax on this money.

But as Uncle Sam pointed out, both you and the taxpayer need to be aware that paying less Social Security tax now usually does have an effect on future Social Security benefits. In many cases it may be only a small effect, but it does affect things.

[ATSMAN]

Never prepared S-Corp return. Is it as intimidating as it seems? Also, one area I keep getting hung up on -

Don't wing it! It may cost you dearly. Partner with another experienced professional and take some courses in addition to studying Taxbook.