S Corp Owners + Compensation
I have consulted many business owners on entity choice. The first question is always should I be an LLC or an S Corporation? This is a multi-layered discussion depending on number of owners, income levels and goals for the business in the future.
I often recommend that the owner consider the S Corporation taxation structure. If they already have an LLC, they can make an election (Form 2553) to be taxed as an S corporation. The key thing is that they understand the interplay between W-2 compensation and K-1 income. They must separate personal and business bank transactions and pay themselves through payroll and shareholder distributions.
S Corporation shareholders must report compensation on Form W-2. The advantage to payroll is that they can withhold federal and state income taxes to cover their tax liability. They will also receive a K-1 which will report profits from the S Corporation. I usually recommend the shareholder increase W-2 withholding to cover the additional tax on the K-1 income.
The W-2 compensation is subject to payroll taxes including social security and Medicare taxes, state employment taxes such as TriMet, Statewide Transit tax etc. The K-1 income is subject to income tax and is taxed at ordinary income tax rates (there is a common misconception that this profit is taxed at capital gains rates - it is NOT!)
S Corporation shareholders must pay themselves a “reasonable compensation.” The W-2 comp is payment for services rendered by the shareholder/employee to the corporation. The amount of reasonable compensation should never exceed the amount actually paid to the shareholder. After a shareholder receives his/her reasonable compensation then the corporation can pay out non-wage distributions of profit.
When I consult an S Corporation shareholder on compensation, many factors come into play. We discuss the extent the services of the shareholder generate revenue for the corporation. If an S Corporation is a service based business and the owner is the only employee or income generating individual in the corporation then compensation should be pretty close to net income.
If the shareholder has many employees or capital equipment that helps to generate revenue then here are some factors in determining reasonable compensation:
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Dividend history
Payments to other employees
What comparable businesses pay for similar services
S Corporation Shareholders Must Treat Medical Insurance Premiums as Wages
Health insurance premiums paid on behalf of a greater than 2-percent S corporation shareholder-employee are deductible by the S corporation and reportable as wages on the shareholder-employee’s Form W-2, subject to income tax withholding. This must be added to the shareholder’s payroll reporting prior to year end W-2 and Form 941s are issued.
These additional wages are not subject to Social Security, or Medicare (FICA), or Unemployment (FUTA) taxes if the payments of premiums are made to or on behalf of an employee under a plan or system that makes provision for all or a class of employees (or employees and their dependents). Therefore, the additional compensation is included in the shareholder-employee’s Box 1 (Wages) of Form W-2, Wage and Tax Statement, but is not included in Boxes 3 and 5 of Form W-2.
The shareholder can deduct the health insurance included on the W-2 on their individual Form 1040. Thus, health insurance included as wages is also a deduction. This deduction is an adjustment to income and a net zero income to the shareholders Adjusted Gross Income (AGI)
Health Insurance Purchased in Name of Shareholder
It is important that the corporation purchase and pay for the health insurance.
Notice 2008-1 provided rules by which a 2-percent shareholder would be allowed an above-the-line deduction even if the health insurance policy was purchased in the name of the shareholder.
Similarly, if the shareholder purchased the health insurance in his own name but the S corporation either directly paid for the health insurance or reimbursed the shareholder for the health insurance and also included the premium payment in the shareholder’s W-2, the shareholder would be allowed an above-the-line deduction.
The bottom line is that in order for a shareholder to claim an above-the-line deduction, the health insurance premiums must ultimately be paid by the S corporation and must be reported as taxable compensation in the shareholder’s W-2.
Choosing to make the shift from LLC to S-Corp is a big one. If you have questions, email us to set up a time to discuss your business’s unique needs.