What is an S Corp and why are they beneficial?
Many entrepreneurs begin their businesses quickly by creating the easiest and most common business structure — a limited liability company. However, that structure, while a good start for liablity protection purposes, isn’t always the most advantageous from a tax perspective.
An S Corp is one of the most tax advantageous structures for business owners, whether the entity was originally formed as an LLC or corporation. The S Corp allows business owners to become employees of their businesses and, thus, pay themselves a “reasonable salary” and earn the tax deductions for their payroll and employment taxes at the same time. Once a reasonable wage is executed, residual profits may be taken as shareholder distributions – which avoids the 15.3% payroll tax on owner salary.
S Corps work well for nearly all single-owner closely held limited liability companies to ensure they receive the best possible tax structure, particularly real estate holding companies or startups looking to raise outside capital from many investors.
“Reasonable Salary” Requirements
As part of the S Corp structure, and the entrepreneur or shareholder becomes an employee, and the IRS requires that a “reasonable salary” be paid to that shareholder if the business is profitable. According to the IRS, “There are no specific guidelines for reasonable compensation in the Code or the Regulations.” The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.
Some factors considered by the courts in determining reasonable compensation:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
The Accounting Lab’s answer to a “reasonable salary” is very nuanced and dependent on industry, revenue, role and more. We work closely with clients to understand their business, cash flow needs, operations and the shareholder or entrepreneur’s role in them. Once we understand our clients, their business, and goals, we can help our clients determine the reasonable salary that should be paid – ultimately looking to optimize between payroll tax exposure, retirement contribution goals, and reasonableness in the eyes of the IRS.
The TAL take on an S Corp
In short, when it comes to S Corps, we love them! The flexibility and tax benefits they provide work for most of our clients and nearly any small business, from physician practices to veterinarians and even accountants. TAL is an S Corp as well.
And while S Corps are extremely beneficial for small businesses for tax purposes, there are still more options and nuances beyond simply creating the S Corp that can ensure entrepreneurs and their businesses pay as little as possible in taxes and maximize their profits and revenue.
To learn more about whether an S Corp and other relevant deductions would be beneficial for your business, reach out to us.
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