Quantifying Entity Elections

The new tax law, the Tax Cuts and Jobs Act of 2017, has created a new set of expectations when it comes to choosing the correct entity for your business.  But one of the things it didn’t do, as far as my analysis can tell, is eliminate the “unreasonable” compensation issue for S Corporations.

I have run several different scenarios comparing the tax and net cash flows for a somewhat typical small business.  I compared the following tax effects:

  • C Corporations paying most of the profits in the form of wages to the owners
  • C Corporation paying nothing but dividends to the owners
  • S Corporation paying wages to the owners of most of the profits
  • S Corporation paying no wages to owners
  • An Operating partnership

Hands down, the continued superior driver of net cash to the owners is driven by the S Corporation paying no wages.  Hands down.  For most small businesses making reasonable profits, the most tax advantageous manner to do this is electing to be an S Corporation and then not paying anything to the owners.

This is so even if the business does not have any other employees so that it can take advantage of the Qualified Small Business Credit of 20%.  This credit is capped at the amount paid in total wages.  Given the rather insignificant differential in tax rates of C Corporations at 21% and the individual rates of ‘Middle income” taxpayers at 22%, there is no marginal difference as far as income tax goes.  The game continues to be the avoidance of payroll taxes.

Hopefully the following scenario will help.  Lets say two friends, Will and Fred, decide to form a fishing guide business called, Will and Fred’s Amazing Adventures.  The Company does $1.0 Million in Revenues, $300,000 in payroll for guides and helpers and a net profit, before paying anything to Will and Fred, of $300,000.

  • As a C Corporation paying $250,000 in wages to Will and Fred, the total taxes paid are $99,000 and net cash to Will and Fred is $176,000 – or $88,000 each.
  • As a C Corporation paying no wages and issuing dividends instead, the Total Tax is $107,000 and net cash to Will and Fried is $200,000 – or $100,000 each
  • As an S Corporation paying $250,000 in wages to Will and Fred, the total taxes paid are $98,000 and net cash to Will and Fred is $201,000 – or $100,000 each
  • As an S Corporation paying no wages and instead paying all earnings as distributions of “profits”, the total tax is $53,000 and net cash to Will and Fred is $247,000 – or $123,000 each
  • As a general operating partnership, total taxes are $90,000 and net cash to Will and Fred is $210,000 – or $105,000 each

A really aggressive tax practitioner would work with Will and Fred to be taxed as an S Corporation and not pay wages.  Most slightly less aggressive practitioners would have them set compensation at $25,000 each.  Zero is hard to defend whereas $25,000 is hard to beat – for the IRS.  I will save that debate for another day but the point is, there is still no disincentive to not pay  wages to the owners.

It is true that there is still better net cash flow to the owner by being treated as an S Corporation than by being taxed as a C Corporation and paying the same wages but no one will say “Gosh that’s good enough for me!”.  Taxpayers will strive for the lowest tax effect and highest dollar return and that still points to S Corporation treatment and low officer wages.  And we are talking about a 20% increase in net cash and a 30% reduction in taxes – no one is going to sneeze at that opportunity.

In summary, the best advice for Will and Fred would be, in the following order:

  • Be an  S Corporation and pay themselves reasonable, but low, wages
  • Be a general partnership
  • Be an S Corporation and pay themselves almost all income as wages
  • Be a C Corporation paying themselves almost all income as wages
  • Be a C Corporation paying themselves no wages and taking all income as dividends

Yes, there are other things to consider – such as health insurance and retirement – but for strictly tax purposes this is how I would advise the owners of Amazing Adventures.

Have a great day.  If you have any questions, feel free to write and ask and if you are interested in discussing how we might be able to help with tax planning and business strategy, feel free to contact us and learn more about how we can work with you.

 

 

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