Tax accounting generally follows straightforward principles: you earn income, pay expenses, and then pay taxes on the net income. However, S-Corp flow-through taxes can be complex and often require extra attention to detail. Following proper procedures can significantly reduce your tax liability. Three key areas where S-Corp shareholders can save on taxes are health insurance, shareholder loans, and retirement plan contributions.
1. Properly handling S-Corp shareholder health insurance
One of the most commonly mishandled deductions for S-Corp shareholders is health insurance. To maximize your tax benefits and avoid costly mistakes, it’s essential to handle these deductions correctly.
Understanding S-Corp shareholder health insurance
An S-Corp can pay for, or reimburse, health insurance premiums for its shareholders, including Medicare and Medicaid prescription costs. However, these amounts must be reported on the shareholder’s W-2 form to be deductible. Doing so allows the company to deduct the costs as wages, and the shareholder can claim these costs as an above-the-line deduction on their personal tax return, effectively offsetting the additional wages reported on the W-2.
Why reporting shareholder health insurance on form W-2 matters
Previously, if health insurance amounts were not reported on Form W-2, they could be listed on Schedule K-1. However, the IRS has tightened regulations, now requiring W-2 reporting. Failure to comply means these expenses must be reported on Schedule A, where they are subject to the 7.5% Adjusted Gross Income (AGI) floor, increasing to 10% under the Affordable Care Act.
Example scenario
Your S-Corp earns $100,000 and you pay $10,000 in health insurance. Failing to report the premiums correctly on the W-2 means you could lose the entire deduction.
Steps to follow
- Report on W-2: Inform your payroll provider of the health insurance amounts to be included on the W-2.
- Be proactive: Ensure health insurance information is provided to your payroll company before they finalize the W-2s—typically within a week after the end of the year.
2. Handling S-Corp shareholder loans correctly
Handling shareholder loans to your S-Corp correctly is also critical for optimizing your tax benefits and avoiding unnecessary tax burdens. While capital contributions can be a great way to build basis and take losses, there are situations where loans are more practical. Here’s how to ensure you manage these loans correctly.
Understanding shareholder loans and basis
Capital contributions to an S-Corp help build your basis, which allows you to take losses. However, when you repay yourself for a loan to the S-Corp that has a reduced basis due to prior-year losses, you must record a pro-rata share of that repayment as income. To avoid adverse tax consequences, prepare a formal promissory note for any shareholder loans. The note should detail the terms of the loan, including repayment schedule and interest rate.
Why a promissory note matters
Without a formal promissory note, any repayment of the loan is treated as ordinary income, subject to your regular tax bracket. Increasing your income can significantly increase your tax liability. Conversely, a properly documented loan allows for repayments to be treated as long-term capital gains, which are typically taxed at a lower rate.
Example scenario
You start an S-Corp and lend the company $100,000 to purchase equipment and buildings. In the first year, you take $100,000 in losses against that loan, reducing your basis to zero. The following year, you repay yourself $50,000 from the loan. If you have a promissory note, the $50,000 repayment is treated as a long-term capital gain, taxed at 15%. Without the note, it’s considered ordinary income, which could be taxed as high as 37%. You can see how a simple documentation step can save you a significant amount in taxes.
Steps to take
- Document the loan: Create a formal promissory note detailing the loan terms.
- Follow repayment terms: Stick to the repayment schedule and interest rates specified in the note.
- Consult a CPA: Work with a qualified CPA to ensure all transactions are correctly documented and reported.
3. Retirement contributions
Retirement contributions can significantly reduce S-Corp flow-through taxes by lowering the overall taxable income of the S-Corp, which in turn decreases the amount of income passed through to the shareholders.
As an S-Corp, the company can make contributions to retirement plans such as SEP-IRA, SIMPLE IRA, or a 401(k) plan on behalf of the employees, including the owner(s). These contributions are considered business expenses and are deductible from the S-Corp’s taxable income.
Shareholder-employees can also make salary deferral contributions to their retirement accounts (such as a 401(k)). These contributions reduce the employee’s W-2 income, which also reduces the flow-through income reported on their personal tax returns.
Example scenario
Your S-Corp has a net income of $100,000. If the S-Corp makes a $10,000 employer contribution to a retirement plan, the net income is reduced to $90,000. This $90,000 is the amount that will flow through to the shareholders and be reported on their personal tax returns, reducing the flow-through income by $10,000. And if a shareholder-employee contributes $10,000 to their 401(k) from their salary, their W-2 income is reduced by this amount, further reducing their personal taxable income.
Steps to take
- Choose the right plan(s): Assess the different types of retirement plans available for small businesses, such as SEP-IRA, SIMPLE IRA, and 401(k) plans.
- Consult a professional: Work with a financial advisor or a retirement plan specialist to set up the chosen plan. They can ensure the plan is set up correctly and in compliance with IRS rules.
Stay compliant to save money
Staying compliant with S-Corp tax rules, especially regarding health insurance, shareholder loans, and retirement plan contributions can save you significant tax dollars. To learn more about how you can take proactive steps to minimize your tax liability, contact us today to learn about the services we provide to S-Corps.