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Ancillary Benefits with S Corporations
By Jason Watson, CPA
Posted Monday, October 23, 2023
As we’ve discussed, the big benefit with an S Corp is the reduction of self-employment taxes. There are some other benefits that we touch on throughout our book, but they are also recapped here-
Section 199A Qualified Business Income Deduction
Once you hit the 32% marginal tax bracket, your QBI deduction either a) phases out if you are deemed to be a Specified Service Trade or Business (SSTB), or b) has a secondary test based on W-2 wages paid and / or qualified property. If you are a sole proprietor, an LLC or a partnership, and not taxed as an S corporation, you cannot pay owner wages. As such, an S Corp election might be necessary allow wages to be paid to the shareholders to resolve the QBI phaseout due to W-2 wages paid.
The quick Section 199A secondary test math goes like this- 20% of net business income (profits) or 50% of wages paid including employee wages, whichever is lower. 50% x $0 is $0, even in Canada.
Pass-Through Entity (PTE) Tax Deduction
Way back in 2017, the Tax Cuts and Jobs Act was passed with a lot of cool tax deductions like the Section 199A qualified business income deduction. But life is one big equalizer, and Congress wanted to limit state and local taxes (SALT) to $10,000. This means either state income taxes or real estate taxes, or both, were severely muted.
So! States got creative and created a state tax that was deducted on partnerships and S corporations tax returns (otherwise called pass-through entities) resulting in lower federal taxable income. This tax is in turn credited on the business owner’s individual tax return for the state. In other words, the business pays for the human’s state income taxes and this lowers the federal income associated with the business.
This also called the great SALT work-around. Cash is cash to a business owner whether it is spent by the business or the human.
Why is the PTE tax deduction considered an S corporation benefit? Your single-member LLC is not considered a pass-through entity, but if you slap an S Corp election on it, you suddenly have this deduction available to you (you can also add another member and tax your LLC as a partnership).
There are all kinds of rules, and not every business owner will benefit from the PTET deduction.
Lower Audit Rate Risk
Travel, meals and auto expenses are the big triggers for a Schedule C audit of your 1040 individual tax return. This is why the IRS calls them out specifically on the tax form. However, with an S Corp (and partnership or C corporation), these expenses are generally tucked away into other deductions. Home office is also tucked away.
S Corporations enjoy a 0.4% audit rate risk versus 3-5%. The best way to win an argument with the IRS is not having the conversation in the first place.
California’s LLC Fee
Without an S Corp election, California’s LLCs fee is based on gross receipts regardless of actual net income after expenses (profits) earned. With an S corporation, this tax is based on 1.5% of the net income (with an $800 minimum).
A Qualified Subchapter S Subsidiary, also known as a QSub or QSSS, is simply an S corporation that’s owned by another S corporation. A QSub is treated as a subsidiary of the parent S corporation. Why do you care?
At times you want to merge two businesses, but the assets are immoveable (think of a Medicare certification or a specialized defense contract). You might need to S elect one before the combination because of certain rules with the merger. You might also want to combine gross receipts for the passive investment income test, or combine basis between stock and loan basis, or combine to release accumulated earnings and profit (AE&P). This is a bit technical, but just a little awareness as you move along in business life.
Taxpayer's Comprehensive Guide to LLCs and S Corps 2023-2024 Edition
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