By Jason Watson, CPA
Posted Sunday, December 29, 2024

We get a lot of calls and emails from business owners who ask about adding their spouse to payroll. There are several reasons where this might make sense, but there are also some pitfalls and things you need to be aware of. Here is a quick list of benefits we will get into, and right after this we’ll discuss the problems.

• Expenses such as meals, business travel, mileage, cell phones, etc. have more deduction capability.

• Increase 401k plan or SEP IRA contributions as a household.

• Social security arbitrage.

• Dependent care credits.

• Leverage the minority owned small business benefits (usually with government contracts). Becoming more rare these days.
• Reduce income base for operating spouse and subsequent reasonable salary testing (huh? Don’t worry… we’ll explore this more).

Problems with Adding Spouse to Payroll

The biggest problem to adding your spouse to payroll is the additional payroll taxes. Before we jump too far into that, let’s talk about how we would determine a reasonable salary if we were adding your spouse to payroll. One of the ways we determine reasonable shareholder salary is by the value of the tasks and duties being performed by the shareholder. This is similar to a market approach analysis that RCReports performs (see our chapter dedicated to reasonable shareholder salaries).

So, we take some of those tasks and duties, split them up between spouses and then we maintain the same total Officer Compensation between two people. Huh? Ok, let’s say Susan is being paid $110,000 by her S Corp. Her husband comes along and does some of Susan’s tasks like bookkeeping and licking stamps. Stamp licking is high-end work. We would then pay Susan $70,000 and her husband would be paid $40,000 for a total of $110,000. Let’s call her husband Mark, the chief stamp licker. There are worse things to be, Mark.

Think of Officer Compensation or reasonable S Corp salary like a pie, and we are just chopping it up into different pieces, some small, some large.

In this example, Social Security and Medicare taxes would be the same between paying just Susan, and paying Susan and Mark together. However, if Susan is being paid $200,000 and we now allocate $20,000 of that to Mark, we just generated an extra 6.2% x $20,000 in Social Security taxes on Mark because Susan’s original salary already exceed the Social Security cap for the 2025 tax year of $176,100. Therefore, this would create unnecessary Social Security taxes… that is bad in case you were wondering seeing how reducing Social Security is one of the pillars of our book.

Also, unemployment is determined on each employee. So, Susan’s unemployment tax is unavoidable and might amount to $350 to $500 depending on her state. Unemployment is similar to Social Security since it has a wage limit, and several states are very low such as $11,000 or so. By adding Mark to the payroll, we suddenly add $350 to $500 in unemployment insurance tax. That too is bad… but not too bad as compared to the possible tax benefits (be patient, we are getting there).

To make things worse, some states have a state disability insurance like California. This piles on to the unemployment insurance tax problem explained above.

Don’t forget that if your spouse is already working somewhere else and receiving a W-2, he or she will be contributing to unemployment all over again by being added to the family business. However, there might be some tax arbitrage explained below.

Business Tax Deductions and Fringe Benefits

Dinners with your spouse could be booked as a business meeting making your meals expense 50% deductible (the 100% deductibility ended in 2022). You likely talk about the business all the time, right? Keep in mind that what makes business meals deductible is that you were meeting to discuss business regardless, and a meal happened to be consumed at the same time. Business purpose first, meal second in terms of the impetus.

Business travel to conferences or other business-related trips can be 100% deductible when your spouse is also an employee. Business trips to Fiji? Probably not. There are rules on extravagance.

What is the break-even on this? Assuming $500 of additional payroll taxes and a marginal tax bracket of 32%, you need $1,600ish of additional expenses that would otherwise be non-deductible. A $100 meal every two weeks gets you to $2,600. You were already spending the $100 every two weeks, and not it becomes deductible. Nice!

Please refer to our chapter on tax deductions and fringe benefits.

401k Plans, SEP IRAs and Social Security

401k plan contributions and other benefits could be extended to your spouse. Currently, employees can defer $23,500 (for the 2025 tax year) plus another $7,500 if they are 50 or older. So, using our example before and assuming Susan is 50, she can defer $31,000 into her 401k. The business could also add another $27,500 (25% of $110,000) as a discretionary contribution for a total of $58,500. Not bad.

If we add Mark to the mix, this $58,500 becomes $89,500 ($58,500 plus $31,000) and it only “cost” you about $300 to $500 in additional payroll taxes. Said in another way, Mark could contribute $31,000 at a 32% marginal tax rate and defer over $9,900 in taxes, and it cost him $300 to $500 in insidious payroll taxes to do so. Not bad.

How would the salaries look in the scenario? We would pay Susan $70,000 to do what she does and Mark $40,000 to continue to lick stamps. They each defer $31,000 into the 401k plan. The business adds another 25% of the combined salaries into the 401k (so, that doesn’t change in either scenario).

Also recall that solo 401k plans often allow spouses to pool their assets (some even allow separate accounts). If you need help with this, let us know. Contrary to some belief, you do not need two solo 401k plans and you don’t need the full version company-sponsored 401k plan unless you hire a person besides the spouses.

We sometimes consider solo 401k contributions and retirement planning as more qualitative than quantitative. Remember, pre-tax retirement contributions are only tax deferrals- IOU’s to the IRS that they patiently wait to collect when you retire. Therefore, when you withdraw retirement money you have to pay taxes. As such, the six-million-dollar question is what are marginal tax rates today versus marginal tax rates in retirement.

The theory is that you take these interest-free IOU’s and parlay them into building wealth. Don’t forget the benefit of deferring state taxes that you might not ever pay back if you relocate for retirement (Pennsylvania has caught on to this trick, and does not give you a tax deferral for 401k plans… no wonder the Eagles stink).

While WCG CPAs & Advisors your financial planner, we strongly recommend Roth contributions into your 401k plan. High contribution amounts ($23,500 + $7,500 catch-up for the 2025 tax year) and no income phase out like a typical Roth IRA. Is it easier to work today to pay a little bit more in taxes, or is it preferred to pull money from savings during your retirement years to pay for taxes? We discuss this more in Chapter 12 (Roth 401k Versus Traditional 401k Considerations).

Each spouse can be contributing to his and her respective Social Security basis and obtain Medicare coverage independently. Some people especially in their 50s and perhaps 60s want to contribute to their Social Security basis. Sounds crazy, but each situation is unique and requires careful planning. So, perhaps this benefit is more of a qualified benefit.

Health Insurance

Some states require businesses to have a “plus 1” on payroll to be compliant on health insurance. Last time we checked on this, Texas was still one of them. As far as we understand the rule, as an S Corp you need to have “you plus 1 other” on payroll to be compliant with the state’s health insurance rules. Adding your spouse might satisfy this.

You might also find that having separate health insurance policies is the way to go… better coverage, lower premiums, or both. But only the health insurance on those who are greater than 2% shareholders can be deducted as an adjustment to income (dollar for dollar) versus a crummy limited deduction on Schedule A. Therefore, in this case, your spouse not only needs to be added to payroll but he or she must also be added as a member or shareholder to get the full deduction of the health insurance premium.

Dependent Care Credit

To qualify for dependent care (like a childcare facility or pre-school) tax credits, both parents must be working, looking for work or be full-time students, or a combination. Therefore, creating a viable job description and having your spouse receive a paycheck allows you to be eligible for dependent care tax credits.

Social Security Arbitrage

There might be a situation where a bit of tax arbitrage can be taken advantage of. Let’s say Susan is being paid $120,000 by her S Corp. Her husband, Mark, makes $180,000 elsewhere. If Susan’s salary is reduced to $80,000 and Mark is added to payroll at $40,000 there will be a $2,480 savings in Social Security taxes. How? Magic.

As an employee, your wage limit for Social Security taxes is $176,100 (for the 2025 tax year). If for some reason (like two jobs) you have wages that were taxed for Social Security taxes in excess of $176,100, you get that refunded on your individual tax return. Only the employee gets the refund, not the employer(s).

So, throughout the year Mark will have $40,000 in wages that were taxed for Social Security taxes by the S Corp. Susan will have $40,000 less in wages being taxed for Social Security taxes. In other words, we essentially take the Social Security taxes that Susan was going to pay and we make Mark pay them, but he has other W-2 income that exceeds the wage limit, so these taxes are refunded.

$40,000 x 6.2% is $2,480. Boom!

Yes, Mark would need to actually do work and be valuable (a stretch, we know), and all those things, but you get the idea.

Spouse As Independent Contractor

Paying your spouse or your children for that matter as contractors can open a can of worms. First, they probably aren’t truly a contractor. Generally, a contractor is someone who holds themselves out to the public as a person in that particular line of work or trade. Second, in the case of an S Corp you are now converting some income that was otherwise not subjected to Social Security and Medicare taxes, and making it so. In other words, you are changing the color of the money but in the wrong way.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

The big theme with S Corps is payroll for shareholders, and what constitutes a reasonable salary. Here are some tricks that you can consider to help reduce, lower or avoid self-employment tax, or Social Security and Medicare tax burdens-

A Shareholder Who Has Other W-2 Income

If you have other W-2 income then you are that much closer to reaching your Social Security wage limit. This in itself is not a trick. But, if you have a business partner who doesn’t have W-2 income, then you can lop side the salary to the shareholder who does. This is especially helpful with a husband and wife team since office politics won’t get in the way. For example, the wife has another job and earns $120,000. Her S Corp salary may be much higher than the husband’s since she is closer to the Social Security cap (which is $176,100 for the 2025 tax year).

Huh? Let’s say the S corporation had to pay out $70,000 in shareholder wages. The employer portion of Social Security and Medicare taxes are a sunk cost regardless of who is paid. However, if the spouse with outside income is paid and he or she exceeds the Social Security limit for the employee’s portion of Social Security taxes, that overage is refunded to the taxpayer.

Of course, salaries must be commensurate with each shareholder’s skill level, hours worked, value to the business, etc. but there is some grey area to work with.

Husband and Wife Team with High Income

Let’s say a husband and wife couple work in the IT field, and combined they earn $600,000. The S Corp could have just one shareholder, let’s say the wife, and the husband is merely a volunteer employee. The wife’s salary could be higher than the husband’s since she is running the business and is the only shareholder. She would reach the Social Security cap much sooner, but this only works if the husband’s salary can remain below the cap.

Let’s illustrate this further-

• Option A- Pay husband and wife $120,000 each for a total of $240,000. All $240,000 would be subjected to Social Security and Medicare taxes.

• Option B- Pay wife $200,000 and husband $40,000. Only $176,100 (for the 2025 tax year) plus $40,000 for total of $216,100 would be subjected to Social Security and Medicare taxes. This $31,400 difference in income subject to Social Security and Medicare taxes between Option A and Option B equates to about $4,800 in cash in your pocket savings.

Again, salaries must be commensurate for the work performed. A cool thing about making the wife the sole shareholder is that the business could gain benefits from being minority owned or considered “disadvantaged” although those benefits are becoming rarer.

Be mindful of the possible reduction in future Social Security benefits from a smaller salary.

Put Your Kids on the Payroll

You can also reduce the business’s overall profits by paying your children to work at the office and paying them a wage. You already have to perform payroll, so you can simply add them to the list. See earlier sections of this chapter and our chapter on fringe benefits and tax deductions for expanded information about putting your kids on the payroll.

Family Management LLC

Similar to above, however, the S Corp pays a management fee to another LLC that is reported on Schedule C of Form 1040 (not an S Corp). Since this garden-variety LLC is not an S Corp, Social Security and Medicare taxes do not have to be paid on wages to children. $9,800 must be paid to the child(ren) to break-even on the costs. IRS risk is moderate since the business connection between the S Corp and the Family Management LLC might not be arms-length or in good faith.

You can also read our Reducing Taxes summary article here-

wcginc.com/6177

Income Splitting as Gift

You can make someone in a lower tax bracket a shareholder in your S Corp to give them money. For example, you are taking care of your Mom and need to give her $10,000 each year to help with expenses. You would need to earn $13,000 or more just to be able to write a check for $10,000. However, if your Mom is in a lower tax bracket, as a shareholder she would pay fewer taxes to pocket the $10,000. And when your Mom eventually passes, her ownership can transfer back to you.

Yes, you could justify not paying Mom a reasonable salary since she is not performing any work for the business. She is simply an investor. However, just like paying your children to work for you, there might be a tax savings by having Mom work- her marginal tax rate could be dramatically lower than yours. Good luck with the “Hey Mom. Want a job?” conversation. What goes around comes around.

Just remember, putting family members on payroll is heavily scrutinized. Make sure the basics such as job descriptions, pay rates, time records, etc. are all in very good order. Memories fade, so document it today!

By Jason Watson, CPA
Posted Sunday, December 29, 2024

An Accountable Plan, under Treasury Regulations Section 1.62-2(C)(2), allows a business to reimburse an employee for expenses incurred in connected with the performance of duties for the business provided proper substantiation is followed (receipts, mileage logs, home office proof, the usual stuff). The substantiation rules are the same for taxpayers in general, but with an Accountable Plan, the “enforcer” is technically the business.

Here are some expenses from Chapter 1, Subchapter B, Part VI: Itemized Deductions for Individuals and Corporations that you might find interesting-

This is a very abbreviated list.

The typical reimbursed expenses through an Accountable Plan are home office use including depreciation, mileage or business-use portion of automobile expenses, cell phone and internet. All these expenses have one thing in common- they are mixed used, both personally and business. Mixed-use expenses should be paid by the employee and later reimbursed. Conversely, anything that is 100% business use should be paid for directly by the business.

The following is saying the same thing, but in bullet form-

• 100% business- Paid by the business, from the business checking account.

• 100% personal- Paid by you, from your personal checking account.

• Mixed- Paid by you, and reimbursed by the business for the business portion.

Of course, if you are reaping some huge cash back or travel deals with your personal credit card, then by all means charge the 100% business use items to your personal card and run those expenses through an Accountable Plan.

Sidebar: The IRS and credit card businesses are butting heads over the rebate programs. It is an ascension of wealth and could technically be taxable income. Whoa! Yup, and the IRS would like 1099s to be issued to show the income. Today, these credit card rebates are considered a reduction in purchase price. This will be battled for the next decade for sure.

Remember that as an S corporation owner, you are both a shareholder and an employee. Therefore, when you are being reimbursed you are being reimbursed as an employee and not as a shareholder.

Also, recall that with the Tax Cuts & Jobs Act of 2017, unreimbursed employee expenses and anything else that was deductible subject to the 2% adjusted gross income limitation are gone after 2017. Therefore, some of this argument is moot and essentially makes deducting expenses at the corporate level and getting reimbursed all that more important… well, since it is the only option.

An Accountable Plan is easy to do, is a great way to pull money out of the business and reduces the amount of taxes paid. Keep in mind too that by reducing your overall net ordinary business income you are also reducing one of the criteria for the reasonable salary testing, and this in turn possibly decreases your salary (and subsequent Social Security and Medicare taxes). A win-win scenario.

Make life easy, get an Accountable Plan. Make life even easier, have us prepare this corporate document and the associated corporate governance documents. WCG charges $150 which includes consultation on how to leverage the most from it.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

In this section we will discuss establishing the salary amount, payroll cadence, tax planning and withholdings, and adjustments.

Establishing the Salary Amount

We’ve discussed the theory behind calculating a reasonable S Corp shareholder salary in another chapter. You are also aware of the benefits of an S corporation such as K-1 income being taxed at the income tax level only, and not subjected to payroll taxes such as Social Security, Medicare, unemployment or disability taxes. This is one of the reasons you are using an S Corp election (probably the only reason).

As the theory of S Corp salary suggests, the amount to pay as a reasonable wage is dependent on you but also on the health of the business. Here’s what we do at WCG-

• During the initial onboarding, we review your qualifications and projected net ordinary business income after expenses and deductions for the year. From that information, we determine a reasonable salary amount. Not too high. Not too low. Goldilocks style.

• Next, we adjust the income tax withholdings to account for your overall income tax obligations as a household. Our goal is to land on tax neutrality which we define as a $1,000 refund from the IRS and a $500 refund from the state. This requires tax planning, which is only done in May, June, July, November and December (the other months are shockingly filled with tax return preparation). As such, if we fire up payroll in Q1 or Q3, then we SWAG it (yes, accountants can SWAG things) and mark our calendars to tighten up the income tax withholdings once the tax plan is done (see Tax Planning below).

• We establish a cash needs number for processing payroll. A general rule of thumb is about 10% over the recommended salary for employer related payroll taxes. For example, let’s say a reasonable shareholder salary is $60,000 or $5,000 per month. The cash that is necessary to be in your business banking account each month is about $5,500 ($5,000 + 10%).

• WCG uses ADP for payroll processing, and our platform is called “Run Wholesale.” Not sure why. But the clever thing here is that we get to say your payroll is on “Run and Done” similar to “Set it and forget it.” Keep in mind future tax planning and adjustments, which we will discuss in a bit. We know, it’s super riveting and you just can’t wait.

Another consideration is a late S corporation election with equally tardy payroll events. Let’s say it is October and we want to go back to January 1 with a late S Corp election, and we also establish a reasonable shareholder salary of $60,000. There are only 3 months remaining, so each month will be $20,000 in salary amounts to account for the entire year. There might be some tinkering with the cash needs if you’ve already paid a bunch of estimated tax payments for the year.

Payroll Cadence

WCG recommends processing shareholder payroll for your S corporation monthly unless you already have a team on a payroll cadence such as bi-weekly or semi-monthly. Some accountants will simply run S Corp payroll once a year in December. In our opinion, this is bad for three big reasons-

• This contradicts your intention to establish a salary based on your credentials, work patterns, complexity of the business, etc. All those theoretical things the IRS and Tax Court use to determine a reasonable salary (we discussed separately in another chapter). To the best of your ability and circumstance, salaries should be forward-looking or contemporaneous, at least have the appearance.

• Running payroll once a year is a horrible budgeting tool. By processing payroll monthly, we ease you into your tax obligations throughout the year. We also tie estimated tax payments into payroll which further helps you budget (more on that when we get into the nuts-and-bolts examples later in this chapter). A $60,000 one-time salary event in December could easily require over $25,000 in cash for tax withholdings. We are all humans first, and budgeters second. Spreading the pain throughout the year helps your cash flow budget and subsequent decision-making (should you buy a new car or a used car).

• Some states will close payroll accounts if you file more than two quarterly payroll filings in a row without salaries or wages. Processing shareholder payroll monthly avoids this issue.

Tax Planning and Withholdings

Estimated tax payments change as well when you have an S Corp, especially the first year. Generally, you are required to pay at least 100% of your prior year tax liability or 90% of your current year tax liability whichever is lower. If you earn over $150,000, you must pay 110% of your current year tax liability. How do you keep that straight?

Here is some more WCG elegance (yeah, we’re bragging a bit)- we calculate and pay your quarterly estimated tax payments through your payroll withholdings. No more writing separate checks or using online payment portals, and tracking due dates. We do this by manually entering your federal and state withholdings accordingly to reflect the tax liability for your W-2 income and your K-1 income, plus other household sources. Beauty!

Technically we are not paying estimated taxes, but we are sending money off to the taxing agencies via payroll.

For example, let’s say you have a net ordinary business income (profit) after expenses and deductions before shareholder salaries of $150,000 and a reasonable salary of $60,000. From there, we look at all household income sources such as your spouse’s income and withholdings, rental income, pension income and anything else that is material to your tax world.

Then we create a mock tax return (the tax plan). That’s right! We extrapolate all this data, pump it into a tax return and determine your tax obligations. We do this periodically throughout the year. Nothing is as accurate as a mock tax return. Yes, you can use Excel or other online estimators, but a tax return is the best tool.

Then we crunch some more numbers. Here is a summary from our internal work paper with some assumptions-

What the heck are we showing you here? The taxable income is making some assumptions such as spousal income, itemized deductions, exemptions, etc. The $184,718 is just a number. Please accept as is.

The tax related to this income is $33,606 according to the mock tax return and your spouse has withheld $8,000 on his or her W-2. The resulting house tax deficit in this example is $25,606. If we simply entered $60,000 into the payroll system and let payroll tables figure out the withholdings it might come up with $7,000ish. This would be a tax surprise in April since you would owe $18,000ish. Yuck. Bad news is OK. Surprises are bad.

This is because the payroll computer does not know about your K-1 income. The net ordinary business income after expenses and deductions from your S Corp tax return. Generally, when you have multiple income sources, especially ones without a withholding component such as K-1’s and rentals, relying on payroll tables to determine withholdings is woefully inaccurate.

You could also have income disparity. For example, let’s say you earn $150,000 and your spouse earns $30,000. When your spouse’s employer computes tax withholdings, the payroll system does not understand that the household income is $180,000. It can only make basic assumptions. In this disparity, even if the $30,000 spouse claims 0 exemptions on a W-4 (max withholdings), the taxes withheld will not be enough when combined with the $150,000.

Our tax planning and income tax withholdings adjustments fix this.

To summarize, we compute your household tax liability and subtract external withholding sources to determine the amount of tax to be withheld from your S Corp payroll. No more estimated payments (usually). No more underpayment penalties. This is a nice way of reducing some chores in your world.

Payroll Adjustments

There are various payroll adjustments throughout the year. Let’s say you onboard with WCG in February. We are going to do a quickie calculation of the reasonable salary and income tax withholdings to get things launched. However, in May, June or July (tax planning months) we are going to dig into the details, prepare the tax plan and make an adjustment to your payroll processing.

Another common scenario is where you might not be able to accurately predict your business activity for the year. For example, a real estate agent in March has no idea how much he or she will earn for the year. But in October and November, there is enough history to predict the future. What we do with this is use a small salary such as $500 per month to check the box, and then make adjustments in July and certainly in November.

Yet another situation is the S Corp owner who is experiencing rocket growth. If we use the previous year as a proxy for the first half of the next year (which is common), a large adjustment must be made in July to account for the growth. The adjustment is not necessarily about salary as it is about tax planning and income tax withholdings.

A common question is “Does it look bad if my salary changes throughout the year?” The answer is simply No. Think of sales and commissions or bonuses. Many professionals and other employees see varying incomes throughout the year. Also, the IRS looks at things in aggregate, and assumes that income and taxes withheld were evenly paid throughout the year. Big swings in income from year to year is certainly a trigger for audits, but a mid-year salary adjustment is not that.

Estimated Tax Payments

Our goal is to increase income tax withholdings to account for your overall household tax obligations. However, there are times when this doesn’t work well, and separate estimated tax payments are necessary. There are two primary reasons for this.

First, you have a low salary relative to your solo 401k plan contribution. For example, a reasonable shareholder salary of $36,000 is determined. You are 52 years old, and want to defer $23,500 (for the 2025 tax year) plus catch-up of $7,500 for a total of $31,000. That leaves $5,000 for Social Security, Medicare and income tax withholdings. Never going to happen, so a separate estimated tax payment will be needed.

The other reason is similar to the above; your shareholder salary is low compared to your K-1 (which is net ordinary business income after expenses and deductions). For example, your W-2 is $100,000 but your K-1 is $500,000. Yes, you have employees so you are not being limited on the Section 199A qualified business income deduction. No, you don’t have enough “room” on your paycheck to increase income tax withholdings to cover the taxes associated with $600,000 in gross income. Even if your effective tax rate with the IRS and the state was only 20%, which is low, it still doesn’t work with a $100,000 W-2.

Unemployment and Workers Compensation

We addressed these issues in Chapter 4. Please review. Here is a summary of the topics-

• FUTA and SUTA- unemployment tax. Unavoidable. You might be able to opt out, and as the Minnesota example in an earlier chapter illustrates, there is a tax savings.

• SDI- state disability insurance. Might be able to opt out for single-owner corporate officers such as California and New York.

• Workers Compensation Insurance- has nothing to do with unemployment or state disability insurance, and is not interchangeable with those terms. This is purely insurance coverage for on the job injuries and is provided by private insurance such as State Farm, All State, Farmers, etc. Ask your local insurance agent if you can opt out. Typically, you can since you don’t plan no suing yourself for a paper cut or a rogue paperclip stabbing.

Salary First, Distributions and Loans Second

We wanted to throw this at you as well. Shareholders must be paid a salary before any shareholder distributions are paid out or loans are advanced to shareholders. This requirement is a technicality. You can take a shareholder distribution as an S Corp owner prior to paying a salary to yourself throughout the year. At the end of the year, however, you must have W-2 income if you received shareholder distributions.

If the business cannot afford to pay salaries, it is not necessarily required to do so. There is some gray area involving large depreciation expenses and other non-cash reductions in business income. So, if you have a pile of cash but experience a loss due to large depreciation, for example, you might still be required to pay salaries. If you believe your business won’t be profitable, then we suggest deferring the S Corp election to another tax year. Remember there are provisions allowing a late S Corp election beyond the customary 75-day limitation- take advantage of this option by delaying your election if you are unsure.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

Remember, payroll taxes (Social Security and Medicare taxes) are the same as self-employment taxes. But they also include unemployment taxes, state disability insurance (such as California’s state disability insurance) and other odd-duck local taxes. We discussed this in previous chapter.

As an S Corp shareholder, you are taking money out of the business in various ways-

Reasonable S Corp Salary

This is a bit obvious, right? Paying yourself a reasonable shareholder salary is a quick way to pull money out of the business. We’ve already touched on reasonable salary theories in an earlier chapter. We will explain payroll processing, tax planning, withholdings and cadence in a bit.

Shareholder Distributions (versus Income)

When you write a check to yourself or transfer money from your business checking account to your personal checking account, you are taking a shareholder distribution. However, you are not taxed on shareholder distributions nor are they a deduction to the business- you are taxed on income (net ordinary business income after expenses and deductions).

Here is a story to drive home this point- WCG CPAs & Advisors has an S Corp client who had accumulated about $400,000 in her business checking account over the years. No big deal. Cash is king, right? Her husband called and wanted to know the tax consequences of moving the $400,000 into their personal checking account since they were buying a house. We said None. You already paid taxes on the income that aggregated to $400,000 over the past three years. Huh?

Let’s say your S Corporation earns $100,000 after shareholder wages and expenses, and you magically also have $100,000 in the business checking account. You transfer $60,000 to your personal checking account as a shareholder distribution. $40,000 is left behind in the business checking account.

What is your taxable income? $100,000. Good.

Next year, your business is a bit slower and you only earn $50,000 and therefore you have $90,000 ($40,000 + $50,000) in the business checking account. You transfer $80,000 to your personal account leaving $10,000 in the business account.

What is your taxable income? $50,000 even though you transferred $80,000 from the business to you. Cash is cash and income is income. As mentioned earlier, over time, aggregated historical cash should be very close to aggregated historical incomes for a stable business. This is mostly true even after accounting for depreciation since this is a mechanism to offset cash outflow for purchases.

This cash is cash and income is income thing can be a real bummer at tax time too. For example, you have $100,000 left over at the end of the year and your taxable income is coincidentally $100,000. You took $70,000 in shareholder distributions as a return on your investment, leaving $30,000 behind for business growth (the reinvestment).

If you are taxed at 24%, you will pay $24,000 ($100,000 x 24%) in taxes on $70,000 worth of net economic benefit from your business- suddenly this becomes painful and a near-35% tax rate ($24,000 divided by $70,000). Something to think about. Keep in mind that this is short-term pain since you are growing your business and hopefully increasing your net economic benefit from it (and adding to your shareholder basis which reduces capital gains should you sell).

We have more information about shareholder distributions including cadence in another section.

Reimbursements (Accountable Plan)

We encourage businesses to create an Accountable Plan which allows employees to turn in expense reports for various reimbursable items. The typical reimbursed expenses through an Accountable Plan are home office use including depreciation, mileage or business-use portion of automobile expenses, cell phone and internet.

All these expenses have one thing in common- they are mixed used, both personally and business. Mixed-use expenses should be paid by the employee and later reimbursed. Conversely, anything that is 100% business use should be paid for directly by the business.

This is also expanded in a later section with some fun journal entries too, Exciting!

Funding Retirement Accounts

Not only can you make contributions to retirement accounts, the business can also fund your SEP IRA, solo 401k plan, profit sharing plan, defined benefits plan, cash balance plan, and other retirement plan mechanisms. We have a whole chapter dedicated to retirement planning within your small business.

Self-Rental

We’ve already discussed self-rentals and how you can pull money out that is only taxed at the income tax level. Here is a re-print of that information-

It is common for a business owner who relies on machinery or equipment to have two business entities. One entity is an LLC that owns the assets. The other entity is an S corporation which leases the assets from the LLC to use in the business. This directly reduces the S Corp’s net operating business income, and might possibly reduce the amount of salary required to be paid by the business to the shareholders. Good news.

Here is an example-

This is an overly simplified example and leaves out depreciation, etc., but you get the idea. In addition, we used a 40% salary calculation simply for the sake of presentation. Your actual salary might be different in your situation. Regardless, the apples to apples comparison shows a nice little savings of $1,692. As mentioned in a previous chapter, the arrangement also allows you to have different partners in each entity allowing you to expand ownership in the operating entity while retaining full ownership in the leased asset (building).

Here is another self-rental situation. You find a business connection for renting space in your home for 14 days or fewer. Client parties and presentations are good examples. Board meetings for closely held businesses is a bad example (or at least one that is tough to defend). Your business enters into a lease arrangement at market rates. The business deducts the amounts paid as rent and issues a 1099-MSIC to you. On your tax return, the amount of rent is reduced to zero with a one-time expense adjustment under Section 280A in the amount of rent.

Adding Children to Payroll

This is another tool in the toolbox to pull money out of your S Corp. You pay your child $15,000 (for the 2025 tax year) or whatever the standard deduction is for that tax year and they spend it on college or gift the money back to you (or they fund a Roth IRA and save the rest for their first home). This is a deduction to you at your tax rate but is tax-free to the child. However, the child pays 7.65% in Social Security and Medicare taxes and the S Corp pays the same.

This usually works well when the parents tax rate is 22% or higher to provide a large enough delta between 15.3% (mandatory payroll taxes) and the parent’s tax rate plus tax credit considerations (since chores are a snap, why not have them work too?).

We expand on this more in Chapter 11, but you can also read our Reducing Taxes summary article here-

wcginc.com/6177

Shareholder Loans

These are generally frowned upon. To truly be a shareholder loan where the S Corp lends money to the shareholder, there must be loan terms including payment, amortization and imputed interest. Shareholder loans have a purpose, but it is narrow and must be carefully implemented.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

The following is a reprint from a blog post and is a quick glance at some of the housekeeping that is required after bringing home your new S Corp puppy.

Open a Business Checking Account

You will need a separate business checking account for two big reasons. First, most payroll processors (ADP, Paychex, Gusto, etc.) require this per Bank Secrecy Act and Homeland Security rules. Second, compartmentalizing your personal and business worlds is just good accounting practice. If necessary, WCG can rebuild your financial statements and prepare tax returns based on bank statements. If your Nordstrom’s is mixed in with Staples, it gets messy.

Yet another reason for the compartmentalization is preserve the separation of you, the personal, from the business. This might, heavy on “might,” help you in a lawsuit or legal matter.

Set Up Payroll Accounts and Processing

As a shareholder of an S corporation, you wear two hats. One as an investor, and another as an employee. Well, that’s a lie. As a business owner, in general, you wear a million hats… but two of them are investor and employee. Therefore, the IRS requires all S Corp shareholders who materially participate in the business activities to be paid a reasonable salary.

A salary is more than simply writing a check or making a transfer from your business checking account to your personal checking account. With a corporation or LLC taxed as S corporation those payments are owner draws and are now considered shareholder distributions. Payroll is payroll… complete with quarterly payroll filings (941s) and annual payroll filings (940, W-2 and W-3). Let’s not forget the state equivalents.

Of course, WCG can handle all this for you, but if you choose to process your own payroll, we strongly recommend ADP or Gusto. WCG uses ADP.

Alert Clients to Payment Changes

You might have been receiving payments under your name and / or into your personal checking account. You will want to notify your clients or customers accordingly. You will also want to supply a W-9 to them alerting them that as an LLC or corporation taxed as an S corporation, you do not need to be issued a 1099-MISC or 1099-NEC (unless you are an attorney… seriously).

However, this is not a rock you want to push up that hill. If a client or a customer, or some ambitious accountant on the other end of the email thread wants to issue a 1099 to your S Corp, don’t fight it. Simply ensure they are using the business’s EIN and not your SSN. It’s just not worth the brain damage to convince someone otherwise.

Understand Mileage, Home Office, Cell Phone, Internet Expenses

If you previously reported your business activities on Schedule C of your Form 1040 individual tax return, there are some things to understand. As we just mentioned, as an owner of an S corporation you are both investor and employee. Investors cannot typically deduct mileage, home office, cell phone and internet expense. And! Employees can no longer deduct these expenses as well thanks to the Tax Cuts and Jobs Act of 2017 (Form 2106 as part of Schedule A was eliminated).

As such, your S Corp must reimburse you, the employee, for these expenses through an Accountable Plan reimbursement program. While it sounds fancy, the big takeaway here is that these expenses were commonly deducted on your individual tax return, but with an S Corp, these expenses are now employee reimbursements and are deducted on your business entity tax return. We will spend a lot of time on this and Accountable Plans in a bit.

Why does this matter? We commonly prepare and file a business entity tax return just to later have the shareholders want to deduct mileage, home office, cell phone and internet expenses on his or her individual tax return. This is a problem and requires amending the business entity tax return. Yuck.

Please don’t wait until the preparation of your individual tax return to let us know that you have mileage expenses or a home office to deduct.

Understand SEP IRA / 401k Limits and Handling

This can be a big surprise, so please pay attention on this one (pretty please). With business activities reported on Schedule C, SEP IRAs and 401k company contributions are based on net business income after expenses. With an S Corp, they are based on W-2 wages paid to the shareholders. Big difference!

One of the reasons for leveraging the tax benefits of an S corporation is to reduce the amounts of Social Security and Medicare taxes (self-employment taxes)… and that is accomplished by paying a reasonable shareholder salary which is less than the net business income (see our wonderful chapter on Reasonable Shareholder Salary). Here is some math-

A business reported on Schedule C earns $100,000 after expenses. A SEP IRA contribution is based on this $100,000 and generally will be close to $18,587 for the sake of argument (20% of net business income after deducting the employer portion of self-employment taxes and adjusting for the contribution factor).

Next assume that this same business being taxed as an S Corp pays out a $40,000 salary to the shareholder. Your SEP IRA contribution is now limited to 25% of W-2 wages, and would be limited to $10,000.

So, if you are used to putting away large chunks into a SEP IRA, you will be in for a surprise.

Sidebar: SEP IRAs are old school and were used in crisis mode since solo 401k plans had to be set up during the tax year. Thanks to the SECURE Act, solo 401k plans can be set up in March, but contributions may be made and deducted as if the plan existed the year prior. Also! Keep in mind that solo 401k plans are way better than SEP IRAs with higher contributions (basically solo 401k = SEP IRA + $23,500 for the 2025 tax year). See our Chapter 12 on Retirement Planning (Using a 401k Plan in Your Small Business Retirement Options).

Wait! There’s more. Similar to mileage, home office, cell phone and internet expenses, SEP IRA and 401k company contributions are deducted on the business entity tax return. Read that again. Before your corporation or LLC became taxed as S Corp decision, you might have been used to calculating a maximum SEP IRA contribution on your individual tax return; with an S Corp, this calculation and the decision to deduct the contribution is done on the business entity (S Corp) tax return.

Know the Filing Deadlines, Business Tax Payments

March 15. There it is… and this seems to sneak up on small business owners who have not filed a business entity tax return in the past. S Corps (Form 1120S) and partnerships (Form 1065) tax returns are due March 15, or the next business day. C Corps (Form 1120) tax returns are due April 15, or the next business day.

Also, your individual tax return cannot be filed until the business entity (S Corp or Partnership) tax return is completed. Why? An S Corp or Partnership tax return creates a K-1 which must be reported on your individual tax return. Therefore, if you are a DIYer and prepare your own Form 1040, please do not file until you’ve added the K-1 to the tax return.

Some states have a franchise or corporate tax that affects S corporations and other business entities. For example, if you were a sole proprietor last year and this year you created an entity in California and elected to have that taxed as an S Corp, the business will be required pay a franchise tax on April 15. The business might also pay estimated tax payments throughout the year for California’s franchise taxes. Texas also has a franchise tax which is due May 15. Other states have other rules.

Again, there are a bunch of additional due dates and whatnot that might come with your new S Corp puppy.

Attention Late S Corp Filers

Things change a bit if you are filing a late S Corp election during the first few months of the year. Let’s use some dates-

Note the problem here… you cannot electronically file the S Corporation tax return (Form 1120S) on-time since you do not have approval from the IRS by March 15. No biggie! One option is to paper file the tax returns, but we’ve seen a ton of problems with that. The other options that WCG uses often is this-

Electronically file a tax return extension on March 15 which is naturally rejected (since the S Corp doesn’t exist yet as a tax election).

• Mail a paper extension to the IRS on March 15 which is probably tossed by an otherwise friendly IRS agent.

• Electronically file the S Corp tax return when greenlighted by the IRS.

• Wait for the nastygram from the IRS saying we were late.

• Submit documentation to the IRS showing the sequence of events, and ask for first time penalty abatement. WCG is batting 100% for over a decade on this.

Your mileage might vary, but this gives you a broad perspective of the sequence when we are close to filing deadlines.

Adjust Estimated Tax Payments

One of the primary reasons, if not the only reason, to elect S Corp status is to reduce self-employment taxes (Social Security and Medicare taxes). If your previous accountant or tax return created estimated tax payments based on the previous year’s data, and before your LLC taxed as S corporation election was made, those vouchers will include the full amount of self-employment taxes. In addition, with an S Corp election and the processing of payroll, self-employment taxes now become Social Security and Medicare taxes and are handled directly through payroll processing.

As such, your estimated tax payments will be way too high and will need adjustments; in most cases, we can eliminate the need of estimated tax payments completely and handle all estimated income tax payments within payroll processing by inflating your withholdings to land on tax neutrality (more on that in a bit).

Accounting, Recording Financial Activity

This is an easy one since whatever you’ve done in the past to memorialize your business transactions remains the same. No, you do not need to instantly add a QuickBooks subscription to your world. While we love QuickBooks Online (QBO) since we can collaborate directly with you, if you have historically used Excel, bar napkins or some other accounting platform, then keep on keeping on.

Nothing changes from an accounting perspective with an S Corp. Yes, there are some minor differences when it comes to Capital Stock and the recording of employee reimbursements, but we can chat about that at tax time.

Let’s dive into this a bit more.

By Jason Watson, CPA
Posted Sunday, December 29, 2024

By Jason Watson, CPA
Posted Friday, June 28, 2024

Small business owners can face some payroll challenges. First, it can be difficult to determine a salary amount for you on January 1st, because salary amounts are somewhat dependent on your business’ financial health, and that in turn can be impacted by seasonal or unpredictable revenue. Think of a realtor whose sales can vary depending on the time of year, and the roller coaster that is the real estate market. You don’t want to overpay shareholder salaries since every $10,000 in salary is potentially $1,500 in unnecessary payroll taxes. That’s problem #1.

Second, cash flow might be lumpy and bumpy, and therefore monthly payroll processing might strain cash reserves. This is common with realtors, like the example above, but it is also common for a lot of consultants or similar professions where you rely on contracts, invoices, purchase order approvals, partial or installment payments, and all the madness in between. Problem #2.

Last, payroll processing cannot be skipped since some states will close your payroll accounts if you do not process “enough” payroll during the quarter. This in turn creates a mess. Additionally, it is inefficient to turn payroll on and off from month to month. Problem #3.

One solution is to pay a minimum salary of $500 per month to the shareholders on an autopilot system. This solves all the problems listed above. Yay! Next, an off-cycle bonus is paid in December using hindsight to “true up” reasonable salary for the entire year.

Also, the beauty of payroll processing and leveraging it to pay income taxes in lieu of estimated tax payments is that the IRS and the state assume salary and income taxes were paid evenly throughout the year regardless of when payroll was processed and the amounts. This approach prevents underpayment penalties but provides flexibility with your cash plus the ability to earn some interest income.

Here is a summary of how minimum payroll with a December bonus works with WCG-

• We get “mins payroll” going and set on autopilot.

• We chat and determine a high and low business profit expectation so we can loosely determine a tax plan for the year. A payroll plan is also created showing the anticipated annual shareholder salary including the big December off-cycle bonus (what we call the OCB).

• Using the tax plan, we determine a “safety percentage” that you set aside when commissions or payments are received. For example, you receive a $10,000 commission check into your business. You set aside or earmark 25% (let’s say) or $2,500 for the December bonus.

• The remainder is used to pay business expenses and can be taken out as a shareholder distribution. You can also “prepay” your 401k employee contribution to leverage dollar cost averaging (but there is some danger here that we can discuss).

• In November, we chat again and use year to date business profit plus the tiny predicted remaining business profit to help set a reasonable shareholder salary for the entire year. From there, we process the OCB.

Having said that, we prefer to have routine and even salary amounts each month if possible. Minimum payroll processing takes discipline to pay out the December bonus.

By Jason Watson, CPA
Posted Friday, November 3, 2023

We’ve mentioned this previously, and we’ll do it again here. Rule #1- Please get a separate checking account for your business, preferably with the same bank as your personal checking account so transfers (shareholder distributions) are easy. Rule #2- Do not pay for personal expenses or any mixed-use expense with business funds.

This is bad for several reasons- the IRS hates it. It erodes the corporate veil which is already dangerously thin since you are a closely held corporation. Lastly, if you need to re-construct your financials because of a QuickBooks disaster or some other calamity, having your business transactions compartmentalized within a bank account makes life better. All money coming in is income. All money going out is an expense or a distribution (or equipment purchase or loan payment).

Read Rule #2 again. It is imperative to keep an arms-length perspective on you, the employee, and relationship with the S corporation. If you worked for Google or Ford, you wouldn’t be able to get the business to buy your groceries or pay your mortgage directly. Same thing with your business. Please refer to our chapter on tax deductions and fringe benefits for a nice table.

By Jason Watson, CPA
Posted Friday, November 3, 2023

Before we go too far down the road, your business needs to track the amounts paid for fringe benefits so they may be included as Officer Compensation on Line 7 of your S Corp tax return and Box 1 of your W-2. Specifically-

• Self-employed health insurance premiums,

• Health Savings Account (HSA) contributions made by the business

• Health Reimbursement Arrangement (HRA) reimbursements, and

• Personal use of business assets such as automobiles and airplanes.

There are others, but these are the biggies. If you are using accounting software or even Excel, each of these should be a separate category. If you wanted to get fancy, you could have an account labeled “Officer Compensation” with sub-accounts being Wages, health insurance, HSA, HRA and Other.

In QuickBooks-ese, it would look like this-

Officer Compensation : Wages
Officer Compensation : Health Insurance
Officer Compensation : HSA
Officer Compensation : HRA
Officer Compensation : Other

At tax time, your profit and loss statement would then be framed and hung on our smart client wall. Yes, we have a not-so-smart client wall too which is thankfully much smaller since it is temporary until we give you the “see… how it works is…” tutoring during a Periodic Business Review.

By Jason Watson, CPA
Posted Friday, November 3, 2023

As mentioned elsewhere in this book, we encourage people to focus on building wealth and if they can save taxes along the way, then that is just icing on the cake. What do we mean here? Often, we see business owners who want to minimize their tax obligation rather than maximizing their business value, and this can be problematic in two areas; lending and selling.

Lending is more straightforward so we will tackle that first. If you are prone to pump a lot of personal expenses such as cars, computers, business trips that have a huge personal component, and other deductions through your business, your taxable income will be decreased. So, when the IRS shakes you down, you calmly say, “all these deductions have a business purpose and are considered ordinary and necessary.” Then you go visit the bank, and you calmly say to the lender, “all these deductions really aren’t business related and as such they shouldn’t affect my credit worthiness or ability to pay a loan.”

Can you see the pickle you are in between minimizing tax and maximizing value?

Selling a business is slightly different. To determine the value of a business, most valuations need to determine seller’s discretionary cash flow (SDCF) which is also considered the net economic benefit. One technique is to start with taxable income, and then make adjustments such as adding back interest expense, depreciation and amortization. Officer compensation and perquisites (the fancy word for perks) are also checked for reasonableness; so, if personal expenses are being rifled through the business, these expenses are added back as well to increase SDCF. There are other adjustments as well, but these are the biggies.

It gets sticky again when the seller provides a general ledger of all his or her transactions, and starts highlighting a ton of stuff “reversing” tax deductions and reclassifying them as personal expenses. A few things here and there are fine, but if there are several material adjustments to SDCF at the request of the seller arguing that the expenses are truly a form of economic benefit to the seller (and future buyer) the credibility of the data starts to wane.

To recap, lenders want net economic benefit to support debt service. Buyers want net economic benefit because that is what he or she is essentially buying (future cash flow / economic benefit). As such, be careful how much you focus on minimizing tax versus maximizing value if you intend to leverage your business for lending purposes (even buying a house counts) or selling purposes.

By Jason Watson, CPA
Posted Friday, November 3, 2023

Sounds ominous doesn’t it? It can be a big ol’ pain in the tax butt frankly. What the heck are we talking about?

We described this in Chapter 4 in good detail but the simple nuts and bolts of shareholder distributions in excess of basis goes like this- let’s say you inject $1,000 into your business as startup capital, and your business has a net ordinary business income after expenses and deductions of $20,000. Your shareholder basis is $21,000. However, due to some interesting accounting dynamics, your business has $30,000 in cash and you distribute $25,000 as shareholder distributions.

You just triggered a shareholder distribution in excess of basis by $4,000 ($25,000 less $21,000), and this creates a capital gain and associated taxes.

Two of the top three reasons this occurs are depreciation and loans which separately create a cash greater than income situation. And the third reason shareholder distributions in excess of basis is bad historical basis data.

Please refer to Chapter 4 for more details. Keep in mind that a shareholder distribution in excess of basis is not always a bad thing; it is taxed as a capital gain which might be leveraged well on a tax return for certain taxable events and positions.

By Jason Watson, CPA
Posted Friday, November 3, 2023

An S Corp must file a corporate tax return (Form 1120S) by March 15 and there are additional financial reporting requirements. Since an S corporation is a pass-through entity whereby the tax consequences are passed through to the shareholders, the individual tax returns (Form 1040) of the shareholders cannot be completed until the S Corp tax return is completed (both can be filed simultaneously). However, if you use WCG CPAs & Advisors to prepare your tax returns, we’ll make it seamless and pain free. Ok, taxes and pain free don’t really go together, but you get the idea.

Balance Sheet (Schedule L)

S corporations file a Form 1120S and this in turn creates K-1s for all the shareholders. Unlike many other tax professionals, we always create a balance sheet, and we always reconcile equity accounts (capital stock, additional paid in capital, retained earnings, shareholder distributions and basis). This can be challenging for us, but we feel it is important for you, the client, and for long-term reporting accuracy.

Creating a balance sheet is also just good accounting practice, and it contributes to the overall tracking of your business’s worth. Lenders and investors will also want to see this information if you need leveraged financial assistance for business growth. Recently, a business owner was gifting away chunks of her business to her sons, and her basis needed to be calculated and transferred for gift tax filings. Her balance sheet information was a mess and needed fixing. We are retained frequently to put humpty dumpty back together and build historical balance sheet information.

Business succession, exit strategies, asset sales, business valuation, buy-sell agreements, etc. are topics rarely considered by most small business owners, and that is okay. But as accountants and business consultants, it is our job to keep you out of future trouble by putting things on the right track today. That starts with your corporate tax returns being comprehensively and accurately prepared, which includes Schedule L (the balance sheet). While we don’t look for ways to complicate the heck out of things, demand that your tax professional prepare a balance sheet with your tax returns.

Shareholder Basis

When you own an S corporation, you are both employee and investor. If you invested $100 into Google, you could only lose $100. Nothing more. The same with your S Corp as an investor. For example, if you invested $10,000 into your business, but your business lost $20,000, your K-1 will show a $20,000 loss but you are only allowed to deduct the loss to the limit of your basis which is $10,000. Without tracking this information, you could be incorrectly deducting losses in the current year instead of carrying them forward to future years.

More importantly, without shareholder basis information, there is no way to determine the gain on your future business sale. Just like stock sales, when you sell your business for a zillion dollars the IRS will consider all that to be capital gain unless you can prove otherwise.

We’ll dig a little deeper into shareholder distributions in excess of basis, and the problems that occur next.

By Jason Watson, CPA
Posted Friday, November 3, 2023

The Accountable Plan is usually drafted as a business policy and later adopted through Corporate Minutes, if your underlying entity is a corporation, and the plan satisfies three basic IRS requirements: a business connection; substantiation; and return of excess amounts-

Business Connection

The expense must have a business connection. Typically, expenses incurred by an employee while doing his or her job usually have a business connection. It might be a good idea to list some examples of things such as home office, cell phone, internet, mileage and meals. Health insurance premiums should be paid by the business directly; however, some states might require premiums to certain state-sponsored plans to be paid individually. In this case, these would be reimbursed through an Accountable Plan.

You could also list conditions and parameters for reimbursement. Must answer phone calls outside the office to claim a cell phone reimbursement. Or only mileage to and from client meetings, delivering product, running errands for supplies, etc. The more comprehensive the allowable business connections, the safer your plan will be.

Proper Substantiation

The employee must adequately account for the business for expenses within a reasonable time. Adequate accounting means completing expense reports and providing the business with receipts, invoices, and other documentary evidence of the expenses. Using a separate credit card and requesting credit card statements is a great recordkeeping technique.

There are special substantiation rules for meals, business gifts and anything considered “listed property.” We can help you with these situations if necessary.

Return of the Excess Reimbursement

The employee must return to the business any excess reimbursements within a reasonable time. While this is not an issue if you are reimbursed only for what you request (what we accountants call after-the-fact reimbursements), you should still detail this policy in your Accountable Plan. Many businesses provide a monthly stipend to cover expenses, and employees are required to return unused portions.

Here is a timeline according to the IRS-

• An advance may be received within 30 days of the time of the expense.

• The employee furnishes an adequate account of expenses within 60 days after they were paid or incurred.

• The employee returns any excess reimbursement within 120 days after it was paid or incurred.

The Accountable Plan should address the above issues, and it should be drafted as business policy for all employees. While different employee groups and individual employees can have different plans, you should draft this policy while distancing it from any favoritism towards the shareholder employees.

For a sample Accountable Plan Excel template and other goodies that you can review please see-

wcginc.com/APlan

By Jason Watson, CPA
Posted Friday, November 3, 2023

Since payroll might be late to the S Corp party during the first year, at times we need to re-classify prior shareholder distributions as shareholder wages (and perhaps employee reimbursements).

Here is a sample journal entry for an S Corp shareholder who took out $20,000 as a shareholder distribution, but later reclassified the transaction as shareholder distributions, wages and employee reimbursements.

When the original distribution took place, there was a debit to Shareholder Distributions for $20,000 and a credit to Cash for the same. We are simply reducing the $20,000 by $8,950 so the actual distribution reflects $20,000 less $8,950 or $11,050.

In other words, Shareholder Distributions was a negative $20,000 in the equity section of your business’s balance sheet. After increasing Shareholder Wage Expense by $7,000 and Employee Reimbursements by $1,950, net ordinary business income is reduced by $8,950. This naturally reduces equity by the same amount therefore Shareholder Distributions must be reduced so equity remains unchanged. No adjustment is made to Cash. Make sense? Don’t worry… we can provide these journal entries as necessary. We are just geeking out on our own silly accounting fun.

If we were putting this transaction into the books together from the start, it would look this starting with the shareholder distribution-

Then the Shareholder Wage Expense and Employee Reimbursements-

Everything would end up in the same spot- Shareholder Distributions at $11,050, Owner Wage Expense at $7,000 and Employee Reimbursements at $1,950. Cash spent would be $20,000. The only difference is the first example is a correcting or reversing entry.

This sample is a slight over-simplification since there would also be a Payroll Tax Expense entry for the business’s portion of Social Security, Medicare, Unemployment, etc. but you get the idea.

By Jason Watson, CPA
Posted Friday, November 3, 2023

The IRS and Tax Court do not like to see you use your business as an ATM machine. This is not because you just said automated teller machine machine. This is because the spirit of a shareholder distribution is to be a return on investment, and if it is magically tied to personal living expenses it looks bad. Think of it this way- you wouldn’t call up Google and demand a dividend because baby needs new shoes, or the boat payment is due. Same thing here.

Another perspective- Apple shareholders are routinely upset because of the cash that Apple hoards. There are two ways to get a return on investment- capital appreciation (and subsequent sale) and dividends. If there are piles of cash and there aren’t immediate or mid-term needs for the cash, shouldn’t that be returned to investors who helped build the cash to begin with?

What do you do? One option is to take systematic shareholder distributions throughout the year, and flush out the remainder once a quarter or annually. Another option is simply distribute large chunks periodically without any cadence or basis that can be tied to personal living expenses. WCG prefers the first option. Looks clean. Defensible.

Sidebar: Lenders do not like to see a bunch of cash in your S corporation bank account. If you are looking to buy a house in the next six months, drain your business bank account down to the operational minimum. Lenders see $100,000 in the business account and they assume the business needs this. You roll up and say you are going to take it all out for a down payment. Now the sales prevention team (i.e., underwriting) thinks your business will suddenly fail which cuts off your ability to service your debt. Next thing you know we must write letters explaining that your business won’t fail because of this cash drain, and it becomes a big headache for everyone.

Here is another consideration. If you pile up money for a handful of years, and then flush it all out in one year, the relationship between income, reasonable shareholder salary and distributions will be unbalanced. Keep in mind that one of the criteria the IRS and the Tax Court use to test the reasonableness of a shareholder salary is the comparison between salaries and distributions. You don’t get rollover credits for all those years where you didn’t take out distributions, and while you can demonstrate the problem in support of your salary why have the conversation at all?

Bottomline- do not leave cash laying around in your business. Earmark it for future short-term purchase, put that money to use immediately, or put it in your personal savings account or retirement fund. Business owners routinely use their business checking account as a personal savings account. Bad. Don’t do it. Run your business like a business, and make sure retained cash has a purpose! Idle business cash has very little upside unless you have a capital expenditure or some other near-future use.

We recently had a client who had a particularly good year. For sake of discussion, let’s say the client had net business income (profit) of about $250,000 before a reasonable shareholder salary. He had a one-and-done project that boosted his net business income to over $800,000. His salary was $90,000, and remained unchanged, leaving about $710,000 in distributable cash (he didn’t have a Section 199A QBI optimization problem).

During our planning meetings, everyone felt uncomfortable distributing more than about $200,000. However, he didn’t want the remaining $510,000 to be idle as cash. Had he taken the full $710,000 out as a shareholder distribution, he was going to invest about $500,000 of it anyway. As such, the recommendation was to leave $510,000 in the business and invest this cash the same way he was planning, but in the name of the business. The plan will be to slowly redeem his investments and distribute this windfall over a handful of years (versus all at once). Same result. Much lower IRS risk.

A common question that is also asked is “If I take too much out, can I return some of the shareholder distribution back to the business?” Yes, you can. This is very common actually. Not elegant or ideal, but common. Things happen. No, this is a shareholder loan or additional paid in capital. It is a return of excess distributions. Keep it simple.

By Jason Watson, CPA
Posted Friday, November 3, 2023

Many business owners ask if they should be cash or accrual when selecting the accounting method within their accounting platform such as QuickBooks Online. Simply put, the accrual-basis method recognizes revenue when earned (not when paid) and recognizes expenses when obligated to pay (but not necessarily paid). Conversely, the cash-basis method recognizes revenue when cash is received and recognizes expenses when cash is paid (mailing a check on 12/31 or swiping your credit card on 12/31 is considered paid in the current year).

There is also a modified cash-basis method of accounting for those who have inventory where generally you are using cash-basis for recording transactions but record all inventory transactions using accrual-basis. Which method should you use?

Yes, there are all kinds of exceptions, rules, thresholds, etc. and other nauseating details. Let’s skip those now. Most small businesses can operate just fine using the cash-basis method of accounting; when cash comes in, it’s revenue. When cash leaves, it is usually an expense or a shareholder distribution (or loan payment or capital expenditure on a monster truck for the office). Easy.

Phantom Income

Cash-basis method also prevents phantom income or paying taxes on bad income. What do we mean?

If you send an invoice on 12/31 but the client never pays, and you forget this, you will pay taxes on phantom income. Or, you send an invoice for $10,000 on 12/31 but the client only pays $6,000 on 7/1 because of a negotiated write-down; you paid taxes on $10,000 and now you must wait until the following year to recognize the $4,000 bad debt expense and subsequent reduction in taxable income. $4,000 times your tax rate might not be a big deal; $40,000 times your tax rate might be a killer since you didn’t get the cash to pay the taxes.

Another scenario is where you invoice a client on 12/31 but because of norms in the industry, they don’t pay for six months. If this is a large invoice you will have fronted the taxes generated by it on April 15 but not get paid until July 1. That can really suck the cash out of your flow.

Cash-basis method of accounting takes the mystery out of this stuff.

Bad Debts in Cash World

One question we get all the time… literally all the time… “I built a website for this dude and he never paid me. Can I deduct the amount he owes me?” It depends. If you are cash-basis then No since you never recognized the income nor paid taxes on it. If you are accrual-basis where you invoiced the dude and recognized the income as taxable, then Yes. To recap, you can only deduct a bad debt if you previously recognized the income, dude or no dude.

Here is another example to hopefully take this home. You are a landlord. Your property is vacant for two months; your taxable rental income is naturally reduced by this vacancy and as such creates a built-in tax reduction (not deduction… reduction… with an r).

Keep in mind that over time accrual-basis and cash-basis converge for most small businesses that are stable and not growing. From year to year things might be different, but after a decade or more, historical net income is virtually identical between accrual and cash. Sure, there are probably extreme and rare examples where this statement fails, but generally speaking it holds.

Accruals in Cash World

There are some nuances that we must take care of in a cash-based world. Four scenarios tend to repeat themselves often-

• You intend to make a 401k employer contribution by March 15. Cash hasn’t left the checking account yet, however, you want to deduct the 401k contribution on your tax return. We would record the 401k Contribution expense (debit) with a corresponding 401k Liability (credit).

• You swipe your credit card for a bunch of expenses in December. You pay the credit card bill in January. The IRS, and the accounting industry, says you can recognize these expenses at the time of credit card swipe. However, cash has not left your checking account by December 31. As such, we record the expenses (debits) with a corresponding Credit Card Payable (credit).

• Your client, on the advice of their smart CPA, sends you a check on December 31 and you receive it on January 2. The 1099-MISC that is issued to you also includes this payment. We align top-line revenue with the total of all 1099s received, and then record a “timing difference” so that part of this revenue is not recognized as taxable income.

• You are part of a multi-entity arrangement where the mothership pays out a fee for service to the baby S Corps. However, December 31 comes and goes, and the final year-end accounting (bookkeeping) has not been done until February. Since the obligation existed on December 31, we record a Fee for Service expense (debit) and corresponding Payable (credit) so that net business income (profit) is reduced correctly.

By Jason Watson, CPA
Posted Sunday, October 10, 2021

We would prefer that employee reimbursements through an Accountable Plan be done as a single check or transfer from the business checking account into your personal checking account (as the employee). This makes the accounting very straightforward- you debit Employee Reimbursements and credit Cash. If you are using QuickBooks, you categorize the check or transfer as Employee Reimbursements with splits for each sub account (home office, mileage, cell phone, internet, etc.).

This is the most elegant.

Otherwise, the processing of an Accountable Plan can be done at the end of each quarter to basically reclassify owner or shareholder distributions as employee reimbursements. For example, let’s say you took out $20,000 over the quarter as distributions. But after completing the Accountable Plan Reimbursement, the business owed you $5,000. We would make an entry to reflect the reimbursement, and your shareholder distributions would be re-classified as a $15,000 distribution (taxable) and a $5,000 reimbursement (non-taxable).

Here is a sample journal entry for an S Corp shareholder who took out $20,000 as a shareholder distribution, but later re-categorized the transaction as distributions, wages and employee reimbursements.

When the original distribution took place, there was a debit to Shareholder Distributions for $20,000 and a credit to Cash for the same. We are simply reducing the $20,000 by $8,950 so the actual distribution reflects $20,000 less $8,950 or $11,050. No adjustment is made to Cash. Make sense?

If we were putting this transaction into the books together from the start, it would look this starting with the shareholder distribution-

And then the Owner Wage Expense and Employee Reimbursements-

Everything would end up in the same spot- Shareholder Distributions at $11,050, Owner Wage Expense at $7,000 and Employee Reimbursements at $1,950. Cash spent would be $20,000. The only difference is the first example is a correcting or reversing entry.

This is a slight over-simplification since there would also be a Payroll Tax Expense entry for the business’s portion of Social Security, Medicare, Unemployment, etc. but this should be illustrative enough.

The “look back” at the end of the quarter might not work if you provide a stipend or some other advance to your employees throughout the period. This is due to the time limits imposed on the substantiation requests and returns of excess reimbursements. Try to avoid the advance or stipend approach.

While the single check or bank transfer is ideal and elegant as we mentioned earlier, Accountable Plan reimbursements are commonly done at tax return preparation. Just like the example above, we reclassify some shareholder distributions as employee expense reimbursements.

The downside to this approach, and why the quarterly method is preferred, is that it throws off tax planning. If we are bouncing along thinking you are going to earn $100,000 but in reality it is $80,000 after Accountable Plan expenses are reimbursed, this could easily swing your tax obligations by $4,000 to $5,000. Sure, it would be in your favor as a tax refund, but it is still not ideal tax planning.

By Jason Watson, CPA
Posted Sunday, October 10, 2021

Let’s back up and talk about the 1099-NEC versus 1099-MISC. The 1099-NEC which stands for non-employee compensation was last used in 1982 until the IRS revived it for the 2020 tax year. Why? No one really knows, but the IRS pawned off the excuse of varying filing deadlines within the 1099-MISC, and to simplify, they spun off the 1099-NEC again.

Receiving a 1099-NEC is another minor inconvenience. Generally, we nominate the income to the business. Mechanically we bring the income into your individual tax return (Form 1040) so it is reported correctly, but then make an adjustment along with notations to assign the income to your S corporation tax return (Form 1120S). Ideally, S Corps should not be receiving 1099-NEC’s at all. You can alert your clients or customers accordingly by completing and submitting a W-9 to each of them (and cross your fingers).

There are certain businesses such as insurance agents, investment advisors, realtors and consultants that might be precluded from receiving income and the subsequent 1099-NEC tax form in the business name and EIN. In other words, your Social Security number is being used to report the income to the IRS.

For certain people in the financial advisory sector, the tides are changing. More and more of these professionals are creating registered investment advisor (RIA) firms, and as such FINRA, the SEC and the higher ups at investment banks are allowing for 1099-NECs to be issued to the business’s EIN instead of your personal SSN. This certainly simplifies things.

Please review the Fleischer Tax Court case in a previous chapter for more details on this conundrum.

By Jason Watson, CPA
Posted Sunday, October 10, 2021

Operating your S Corporation is generally a no muss no fuss situation, but there are several considerations to be aware of. Here is the order of business for this chapter-

• Costs or Fees for Having an S Corp

• I Just Got an S Corp Puppy, What Do I Do?

• Processing Payroll, Tax Planning

• Shareholder Distributions

• Other Considerations and Tricks

Tax deductions and fringe benefits including retirement planning are in later chapters.