S Corp Tax Saving Strategies: Smart Planning and Words of Warning
Small business owners operate on slim margins, so it’s only natural to look for ways to save money. If you’re an owner of an LLC, you could reduce the amount of taxes you owe by electing to become an S Corporation (S Corp), a popular business structure that couples the tax advantages of a partnership with the legal protection of a corporation.
Several S Corp tax saving strategies could reduce your taxable income and save money. However, none of them should be undertaken without a corporate attorney versed in tax law by your side. In this article, we offer some common methods to reduce your corporate tax burden and some examples of how each one can go awry when used incorrectly.
How to Lower Tax Bill for S Corp
S Corps provide several options for reducing taxes that are not available for sole proprietors or LLCs taxed as partnerships. S Corps also allow profits and losses to pass through to the owners’ personal tax returns, avoiding the dreaded “double taxation” of C Corporations. In addition, S Corps filing before 2025 could qualify for a 20% qualified business income deduction through the Tax Cuts and Jobs Act of 2017.
Here are some of the top S corp tax savings tactics to consider:
Set Reasonable Owner Wages
Shareholders in an S Corp are compensated in two ways: a salary and distributions. The IRS requires S Corp owners to pay themselves a salary that is subject to payroll taxes. However, any additional profits that are given as distributions are not subject to payroll taxes.
As you can see, the temptation is to pay yourself as low a salary as possible and maximize compensation by distributions. To prevent misuse, the IRS requires shareholders to be paid “reasonable compensation” in the form of a salary—in other words, the going rate for an employee in your position with your experience and job duties.
The trick is determining what constitutes a reasonable salary. Set your salary too low, and the IRS may reclassify your distributions as wages that can be subjected to more taxes. But set it too high, and you’ll overpay payroll taxes unnecessarily. Aim to set your salary based on industry averages for your position and responsibilities. Work with your accountant to find that sweet spot.
More recently, many accountants have obtained software that computes what should be your reasonable compensation as an owner. This analysis is invaluable to ensuring that your calculations are accurate.
Two of the biggest mistakes that people make with their S Corp election are: 1) not paying a portion of compensation as W2 salary; and, 2) setting that compensation level too low.
Employ Your Children
Believe it or not, you can actually hire your spouse or children to work in the business and gain tax deductions. As long as they are doing legitimate work for reasonable pay, the S Corp can deduct their wages and compensation just like any other employee. There are certain restrictions on employing children, but if they qualify, they could receive tax-free income through the S Corp.
However, there are many reasons that you do not want to have your children on the S Corp’s payroll. Depending on your state law, it would cost you more money to employ them through the S Corp rather than through a separate entity.
Max Out Retirement Plan Contributions
By establishing a retirement plan like a 401(k) or SEP-IRA, an S Corp can contribute pre-tax dollars towards owners’ and employees’ retirement. The employer contributions are tax deductible for the business. And it allows owners to make larger retirement contributions than they could through an individual IRA. For 2023, you can contribute up to $61,000 towards retirement through an S Corp plan. Reducing your taxable income now will benefit you tremendously down the road.
If it’s just you in your business, this could be one of the biggest asset-building opportunities of all!
Rent Your Home
Renting your personal residence to your S Corp for meetings and functions is another potential tax planning strategy. The rental income you receive personally would be passive income, allowing it to be offset by any passive losses you have. If the S corp uses the space exclusively and regularly for business, you can charge fair market rent and still deduct rental expenses.
Your business can rent your home from you for up to 14 days, allowing the business to deduct the rental expenses. The S Corp can also deduct expenses like utilities, repairs, insurance, and depreciation. However, you’ll need a formal lease agreement spelling out rental terms to show the arrangement is at arm’s length.
Just like there are fantastic opportunities for success, there are similar opportunities for problems. This strategy gained quite a following through social media; however, you must ensure you have proper documentation to support this deduction.
Use Business Deductions to Lower Your S-Corp Income Tax Rate
There is a wide range of ordinary and necessary business expenses S Corps can deduct to lower their taxable income. Maximizing the following deductions can mean a savings of thousands of dollars for your company:
Home Office
From furniture and computers to letterhead and wifi, home office costs can quickly add up. S Corp owners can be reimbursed for these expenses, allowing your furnishings and office necessities to be paid for tax-free. Common deductible items include pens, paper, folders, software, subscriptions, books, and general supplies used for daily operations. The costs to repair equipment and maintain business property are also deductible.
You should be aware that using the Augusta Rule strategy will likely prevent you from using the home office deduction too. Also, this deduction is one of most popular ones to trigger an audit.
Depreciation
The tax code also provides very generous first-year bonus depreciation that allows businesses to immediately deduct a large percentage of the cost of most assets like equipment, furniture, and machinery. This allows you to expense the entire purchase price upfront rather than depreciating it slowly over time.
Bonus depreciation started phasing out last year. It will decrease by 20% per year until 2027, which is when it will be gone. For 2024, it’s 60% bonus depreciation. Use it or lose it!
Vehicles
Businesses can deduct gas, repairs, maintenance, lease payments, insurance, registration fees, and mileage for vehicles used for business purposes. These deductions can be taken by either combining all expenses and claiming the business-related portion, or by claiming a flat rate for every business mile driven (called the standard mileage deduction).
You could combine this with the bonus depreciation strategy above too!
Employee Benefits
Fringe benefits are one of the most popular S Corp tax saving strategies. Things like health insurance premiums, education reimbursement, cell phone stipends, retirement plan contributions, and other fringe benefits offered to employees are deductible expenses. These benefits reduce your taxable income while allowing you to attract and retain top talent.
Insurance
Premiums paid for general liability insurance, property insurance, commercial auto insurance, business interruption, cyber insurance, and other policies that cover business risks are deductible. Health and dental insurance for employees is also deductible.
Travel Expenses
Airfare, hotel, rental cars, taxis, mileage, meals (subject to 50% limit), tips, parking, and other travel costs for business trips are deductible. However, the IRS keeps a close eye on travel-related deductions, so make sure you document the purpose of each trip and keep copies of receipts and expense reports.
Professional Fees
Advertisements, online marketing, promotional products, trade shows, direct mail, and business cards can be deducted as marketing expenses. Domain names and website hosting also qualify. Fees paid to lawyers, accountants, consultants, bookkeepers, designers, and other professionals are deductible expenses, as are outsourcing costs.
Accurate Records Are Key to S Corp Tax Saving Strategies
We cannot stress this one enough!!! Planning ahead and working closely with your tax advisor can help you execute S Corp tax saving strategies like these to maximize write-offs. Unfortunately, failure to back up deductions with records and receipts is the most common reason tax plans fail (and business owners end up in court).
Consider a recent case where an S-Corp owner attempted to collect tax-free rental income and claim a rental deduction for business use of his own property. The owner’s tax advisor recommended setting the rental rate according to comparable independent spaces within a 100-mile radius. The advisor also suggested getting a professional appraiser to reevaluate the rental rate every few years.
For three years, the S-Corp rented each of the owner’s residential properties for 14 days each at several times higher than the market rate. When the matter went to court, the owner maintained that the rate was reasonable but failed to produce evidence of comparable properties. The IRS disallowed the entirety of the rental deductions, imposing significant penalties and back taxes on the S Corp.
Don’t Try Tax Planning Without a Corporate Tax Attorney
Case law is littered with examples of tax planning gone wrong. Considering how much is at stake, tax strategies should only be done with experienced counsel.
If you have any questions or need assistance with your tax plan, email us at hello@yolofskylaw.com today or schedule a 15-minute call.