Let’s back up a bit. Our book loves to spill the beans so-to-speak with the net-net fun facts, and then dig a hole under the house for the foundation. Wow. All kinds of metaphors. There are three types of income- earned, portfolio and passive. There is also a small subset of passive income called non-passive income.

Earned Income

Earned income is income that is a direct result of your labor. This income is usually in the form of W-2 wages or as small business income reported on Schedule C of your individual tax return (Form 1040), both subjected to Social Security and Medicare taxes (self-employment taxes). There are other areas such as Schedule E or F where income can come into your individual tax return and be subjected to self-employment taxes, but Schedule C is the most common.

Portfolio Income

Portfolio income is income generated from selling an asset, and if you sell that asset for a higher price than what you paid for it originally, you will have a gain. Depending on the holding period of the asset, and other factors, that gain might be taxed at ordinary income tax rates or capital gains tax rates. Interest and dividends are other examples of portfolio income.

Capital gains are not a form of income per se. Capital gains simply defines how your portfolio income will be taxed. Income is income, and is therefore taxed. This income might be taxed at capital gains rates or ordinary rates. Subtle difference.

Portfolio income is not subjected to self-employment taxes, but as illustrated earlier it might be subjected to net investment income (NII) Medicare surtax.

Passive Income

We touched on this in a previous section. Passive income bluntly is income that would continue to generate if you died. Morbid. How about this? Passive income is income that would continue to generate if you decided to do nothing and sunbathe on some beach. That sounds better. Passive income includes rental income, royalties and income from businesses or investment partnerships / multi-member LLCs where you do not materially participate.

Passive income is also not subjected to self-employment taxes. But similar to portfolio income, it might be subject to the Net Investment Income tax. So, if you own a rental house, the income generated from the rental house is considered passive income although your participation might be considered active. If you take this same rental, and provide short-term rental periods and offer certain services, your income might be considered earned income. Rentals pose all kinds of problems.

Sidebar: Taxpayers used to label themselves as Real Estate Professionals under IRS definition to allow passive losses to be deducted; now we are seeing the same label to avoid Net Investment Income tax on rental income.

Additionally, if you wrote a book and receive royalty checks, that income is also passive and not subjected to self-employment taxes. But, if you write several books or make updates to an existing book (like this one) then you are materially participating in your activity and your income is earned income. And Yes, you would pay self-employment taxes on that income.

Non-Passive Income

But there is another funny thing. K-1 income generated from an S Corp where you materially participate is considered non-passive income. It is not necessarily earned income and it is not passive income. It is something in between, but definitely without the Social Security and Medicare tax element.

As an aside, expatriates, or expats for short, can exclude up to $130,000 (for the 2025 tax year) of earned income while working overseas. Many establish S corporations stateside for their contract gig- both the W-2 and K-1 income up to $130,000 are excluded from income tax.

Therefore, as a shareholder in an S corporation you will receive a K-1. How this income is labeled can change depending on your involvement. Material participation makes your K-1 income non-passive, otherwise it is passive income. As mentioned earlier, this changes the color of money in certain tax applications.

Where is this all leading to? Good question.

More Net Investment Tax, Self-Rentals and S Corps

The Net Investment Income Tax was a topic that was briefly broached earlier. Generally, passive income such as long-term rental income will be considered net investment income and subject to the Medicare surtax. Why do you care? Yes, we ask that a lot.

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-

	S Corp Owns Building	LLC Owns Building S Corp Rents from LLC
Gross Income	100,000	100,000
Rental Expense	0	30,000
Net Income	100,000	70,000
Reasonable Salary (assumed at 40%)	40,000	28,000
Payroll Taxes	5,640	3,948
Savings		1,692

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).

More good news. The LLC’s activities are considered self-rental activities which means that you are creating a transaction with yourself. Provided that this arrangement is at market rates, the IRS accepts this relationship. Moreover, the self-rental income is not considered passive and therefore not subjected to the Net Investment Income Tax calculations.

We know what you are thinking… wait for it… Yes, this changes the color of money (how many times have we said this?).

Here is the code. Treasury Regulations Section 1.469-2 boringly reads-

Read that first paragraph again. Only attorneys and legislators could have taken a simple concept and made it unnecessarily complicated. Let’s summarize. If you have a self-rental situation with a business where you materially participate, that income is not considered passive income.

Self-rental situations are not just limited to buildings. You could lease your car to your S corporation. No, this isn’t the same as leasing a car from a dealership. This is where you own a piece of equipment, let’s say an automobile, and you lease it back to your business for your business’s use. Sounds exotic, but it is quite simple. More about this in a later chapter dedicated to fringe benefits and tax deductions.

This is about the equipment used in your trade or craft. Field engineers and landscapers are just a few that come to mind who benefit from a self-rental situation.

Wait! There’s more. There’s always more.

Interest income generated from loans to the S corporation are also excluded from the Net Investment Income Tax calculations to the extent of your allocable share of non-passive deduction. Huh? Example time.

Jim Smith and Sharon Jones own JS Toys as 60-40 partners. Jim received $1,000 in interest income from the business because he lent the business money. Jim owns 60% of the business. Therefore, Jim can exclude $600 from his net investment income since that is his allocable share of non-passive income. The remaining $400 would be subjected to the Net Investment Income Tax calculation. Yes, we accountants love a stupidly convoluted tax code- keeps you confused or bored, and keeps us employed.

Make sure this stuff is handled correctly. You might be paying a Medicare surtax gratuitously.

Here is a little teaser: you would never want to own real estate in your S corporation, or any appreciating asset for that matter. We’ll explore this in our next chapter.

Income Types Recap

We talked about a lot of things regarding the type of income and how it is treated. Here is a brief recap-

• Earned income is subjected to self-employment taxes for self-employed, or payroll taxes in the form of Social Security and Medicare taxes for the W-2 employee. Easy.

• Portfolio income is generated by selling assets and is taxed at the capital gains rate or ordinary income tax rate depending on how long you owned the asset. Interest and dividends are also considered portfolio income. Also easy.

• Long-term rental income is considered passive income which is taxed at the ordinary income tax rate only (as opposed to being taxed twice, once with self-employment taxes and again with ordinary income taxes). Rental losses are considered passive losses.

• Passive losses can only be deducted from passive income, generally. But there are exceptions, of course.

• Passive losses might be deducted against other forms of income such as earned income, portfolio income and non-passive income up to a $25,000 limit. This requires your participation to be considered active, which is a much easier threshold than material participation. Usually 100 hours will do it.

• The deduction of passive losses with active participation becomes limited when modified adjusted gross incomes exceed $100,000 and are reduced to zero at $150,000. Those disallowed losses are carried forward into the future to be used when incomes or dispositions of assets allow.

• Non-passive income cannot be offset or reduced by passive losses except the magical $25,000 figure. So, if you have $100,000 in passive losses from your rental properties and $100,000 in income generated from your self-rental to your business, your non-passive income can only be reduced to $75,000.

• There are PIGs (Passive Income Generators) which have been under IRS scrutiny as abusive tax shelters since their sole purpose is to generate passive income in the beginning to offset other passive losses.

Tilt. This can be confusing. Please contact WCG CPAs & Advisors for more assistance and hopefully clarification.

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

Previously we showed you a mock-up of a W-2 with self-employed health insurance premiums added to Box 1 as Wages. When you have a solo 401k plan and make employee (you) deferrals, that reduces Box 1 of your W-2. However, Line 7 of the corporate tax return will still show the gross salary paid plus self-employed health insurance premiums as Officer Compensation.

In other words, contributing to a 401k plan does not reduce your Officer Compensation below a level where the IRS might challenge your reasonable salary determination. If you worked for Google making $100,000, and Google collects $23,500 and sends it off to the 401k people on your behalf, Google’s wage expense remains at $100,000. Same thing here.

Let’s geek out with a journal entry assuming $50,000 reasonable salary calculation with a $10,000 self-employed health insurance premium and an $23,500 employee pre-tax deferral-

DR Shareholder Wage Expense	40,000
DR Self-Employed Health Ins.	10,000
DR Payroll Taxes	3,060			(7.65% of $40,000)
CR 401k Liability		23,500
CR Cash		29,560

Line 7 Officer Compensation would read $50,000, but Box 1 of your W-2 would read $50,000 less $23,500 for 401k or $26,500. Your adjusted gross income on your individual tax return would be $26,500 less $10,000 for health insurance or $16,500. Yes, we would have K-1 income of some mystery number but you get the idea.

We will give you more examples including a table showing how this shakes out in our chapter on S Corp salaries. Super fun!

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

A common complaint from those who own their own business is self-employment tax. Can you avoid, reduce, eliminate or lower your self-employment taxes or SE taxes? Ok, we just said two things that mean the same thing twice. Yes, you may reduce self-employment taxes to a large extent, but it takes some effort starting with an S Corp election (let’s not get ahead of ourselves yet).

If you own a business as a sole proprietor or as a garden variety single-member LLC (one owner or member) your business income will be reported on your personal tax return under Schedule C and is subject to self-employment tax (currently 15.3%) and ordinary income tax. So, you could easily pay an average of 40% (15.3% in SE taxes + 24% in income taxes) on all your net business income in federal taxes. Wow, that sucks!

A similar taxation exists for partnerships / multi-member LLCs too since the issuing K-1 will identify the income subjected to self-employment taxes (and of course income taxes, just like the example above).

The “double” taxation should not be a stranger to you. When you were paid a W-2 salary of wage, you had Social Security and Medicare taxes taken out of your paycheck, and you also had income taxes withheld based on some payroll table. Only income taxes were “negotiated” by deductions and credits; Social Security and Medicare taxes were not.

Back to the sole proprietors and LLCs. We are all humans, and we generally spend what we make. If you are not prepared for 30% to 40% in taxes for your business income, it could be a shocker on April 15.

The recent tax reform and specifically the pass-through taxation changes in Section 199A do not alter the theory of self-employment tax savings. The additional pass-through deduction afforded to small business owners complements the benefits of an S corporation. Please bear with us as we go through the mechanics of saving self-employment taxes with an S Corp.

How Self Employment Tax Is Computed

A bit of disclosure is in order. Self-employment taxes are 15.3% which is derived from the “employer” portion at 7.65% and the “employee” portion of 7.65%. However, a small business gets to deduct its portion of payroll taxes from income before determining the taxable income. Huh?

Think of your last job where you received a W-2. The employer might have paid you $100,000 and withheld your portion of Social Security and Medicare taxes on your behalf. The business also had to pay its portion of Social Security and Medicare taxes, so its total expense was the $100,000 salary plus $7,650. Similar concept with sole proprietorships and LLCs.

Here is an illustrative table-

Net Business Income	100,000
less SE Tax Adjustment at 7.65%	7,650
Taxable Business Income	92,350
SE Tax at 15.3%	14,130
Tax Deductible Portion	7,065

Do you see the $14,130 or 14.13% of $100,000? That is essentially your effective rate of tax on self-employed business income because of the deductible portion of 7.65%. Probably doesn’t make you feel any better but there you go.

Quick Analysis of S Corp Savings

If you own a business and have elected to be treated as an S Corp (Subchapter S) for taxation, the business now files a corporate tax return on Form 1120S. We will detail this out with a fancy graphic, but basically an S corporation chops up the net economic benefit to the owner between salary and net ordinary business income after expenses and deductions. This split is important. Why?

The salary is subjected to Social Security and Medicare taxes; the net ordinary business income is not. The salary is paid to the employee (you). The net ordinary business income may be paid to the investor (also you). You’ll see several references to this concept that as an S corporation owner you are both employee and investor.

Let’s look at some quick numbers. These are based on using a salary of 40% of net ordinary business income after expenses and deductions for amounts up to $500,000 and then decreased incrementally to 30% for the millionaire at $2,500,000 below (real case actually). The 40% / 30% is for illustration (we will discuss reasonable shareholder salary in silly detail in a later chapter dedicated to only reasonable salary determinations).

Here is our summary table-

Income	Total SE Tax	Salary	Total Payroll Tax	Savings $$	Delta %
30,000	4,239	12,000	1,836	2,403	8.0%
50,000	7,065	20,000	3,060	4,005	8.0%
75,000	10,597	30,000	4,590	6,007	8.0%
100,000	14,130	40,000	6,120	8,010	8.0%
150,000	18,711	60,000	9,180	9,531	6.4%
200,000	20,050	80,000	12,240	7,810	3.9%
300,000	22,972	120,000	18,174	4,798	1.6%
500,000	29,991	200,000	20,494	9,497	1.9%
750,000	38,764	262,500	22,307	16,457	2.2%
1,000,000	47,537	350,000	24,844	22,693	2.3%
2,000,000	82,630	600,000	32,094	50,536	2.5%
2,500,000	100,177	750,000	36,444	63,733	2.5%

Chart Notes

Let’s review some interesting things about the data on the previous page.

The bulk of payroll taxes are Social Security and Medicare taxes, which are combined to be called FICA taxes when payroll specialists are kicking it around the water cooler. You might have other payroll taxes such as unemployment (Yes, some states require it even for one-person corporations) and state disability insurance (SDI).

As mentioned, salaries started at 40% through $500,000 and then reduced to 30% at $2M and $2.5M. This is a jumping-off point. The IRS standard is “reasonable shareholder salary” which includes all sorts of non-qualitative things such as your expertise, Bureau of Labor Statistics, comparison of salary to distributions, zodiac sign, favorite color, etc.

Social Security taxes of 12.4% stop at $176,100 (for the 2025 tax year) of net ordinary business income for LLCs and partnerships who do not elect S corporation status. It also stops at $176,100 for salaries paid via typical W-2 payroll.

Medicare taxes of 2.9% continues into perpetuity. Not only does this go on into perpetuity, it also goes on forever (yes, that is supposed to be a joke). This is one of the major components of savings in the upper incomes since Medicare taxes are capped at the amount of salary with S Corps. In other words, if you earn $1M you will pay Medicare taxes on the entire net ordinary business income, but if you elect S Corp status and pay yourself a $400,000 salary you only pay Medicare taxes on the $400,000.

The Medicare surtax starts for those earning $200,000 and filing single, and $250,000 for those filing jointly. This too continues into perpetuity for LLCs and partnerships. In the data, we assumed a joint tax return. For example, at $500,000 net ordinary business income there is a $1,906 Medicare surtax. But if this business elects S corporation taxation and pays $200,000 salary, there is not a Medicare surtax. There is not a net investment income (NII) tax on the S corporation ordinary income either (more on that loophole later) since you materially participate; in other words, your investment into your S Corp is not passive.

Savings as a percentage of income starts to drop off at $176,100 which makes sense given the Social Security wage cap for the 2025 tax year. And those savings bottom out around $300,000 net business income and then begin a decent climb rate. Without getting into excruciating details and mental gymnastics, there is an interesting dynamic at $300,000 between Medicare taxes including the surtax on the LLC / partnership income, the salary being paid within an S Corp election, and Medicare taxes associated with that salary.

The Source of the Savings

The S Corp election of your Partnership, LLC or C corporation changes how the business reports income to the IRS. An S Corp prepares and files a Form 1120S which is a corporate tax return. That in turn generates a K-1 for each shareholder. Remember, shareholder, investor and owner are synonymous terms for our discussions.

This might be your first brush with the term K-1. A K-1 is similar to a W-2 since it reports income and other items for each member, partner, shareholder, owner or beneficiary, and is coded to tell the IRS how the business activities should be treated.

A K-1 is generated by an entity since the entity is passing along the income tax obligation to the K-1 recipient (hence the concept pass-through entity, or PTE for TLA lovers). There are three basic sources for a K-1, and the source dictates how the income and other items on the K-1 are handled on your individual tax return (Form 1040). Here they are-

• Partnership / MMLLC (Form 1065)

• S Corporation (Form 1120S), and

• Estate or Trust (Form 1041)

There are two types of K-1s for the purposes of our self-employment tax conversation- one is generated from a partnership tax return and the other is generated from an S corporation tax return. These K-1s look nearly identical and both are reported on page 2 of Schedule E in conjunction with your Form 1040. Schedule E is the tax form used for rental properties, royalties and other investment income including business income from a partnership or an S Corp.

However, a K-1 generated from a partnership tax return which has ordinary business income in box 1 and / or guaranteed payments in box 4 will typically be subjected to self-employment taxes for an active partner or member. Conversely, ordinary business income in box 1 on a K-1 from an S corporation will not be taxed with self-employment taxes. The S corporation election changes the color of money (we love this saying).

Note: S Corps do not have guaranteed payments like partnerships might- S Corps would call these payments wages or salary. A partnership (and an LLC for that matter) cannot pay its partners or owners a wage or salary. The IRS frowns on this. Any periodic payment that is recurring in a partnership to one of the partners is called a guaranteed payment and is reported separately from partnership income. Both might be subjected to self-employment taxes.

You just heard the term “pass-through entity” and you might also hear the term “disregarded entity”- a disregarded entity is a single-member LLC. As the terms suggests, it is disregarded for tax purposes, and therefore does not have to file its own tax return since the taxable consequence is reported on the owner(s) individual tax returns (Form 1040) as a sole proprietorship (Schedule C).

A pass-through entity passes its federal tax obligation onto the partner of a partnership, the member of an LLC, the shareholder of an S corporation or the beneficiary of an estate or trust. States might impose a business tax or a franchise tax on the partnership, LLC or S Corp directly (they legally cannot impose an income tax… more about interstate commerce rules later).

Quick Recap, The S Corp Money Trail

So, when your partnership, LLC or corporation is taxed as an S Corp you are considered both an employee and a shareholder (think investor). As an employee being paid a salary, your income is subjected to all the usual taxes that you would see on a paystub- Federal taxes, state taxes, Social Security taxes, Medicare taxes, unemployment and disability.

However, as a shareholder or investor, you are simply getting a return on your investment. That income, as the Romneys, Gates and Buffets of the world enjoy, is a form of investment income and therefore is not subjected to self-employment taxes (tiny exception for income over $200,000 (single) or $250,000 (married) where Medicare surtax is charged).

As you recall, when we say self-employment taxes, we are really talking about Social Security and Medicare taxes. From a sole proprietor perspective, they are self-employment taxes. From an employee perspective, they are Social Security and Medicare taxes. Same thing.

Let’s look at another visual in terms of how the money travels-

The four boxes on the left is the money trail of your sole proprietorship, LLC or partnership. The series of boxes on the right is the money trail of your entity being taxed as an S corporation. Note the $60,000 chunk of income on the far right hand side that is not being taxed at the self-employment tax level. This is the source of your savings.

Also note that all your $100,000 is being subjected to income taxes. This is a common misconception- a lot of business owners believe there is a magical income tax reduction with an S Corp election. Not true. The only reduction is in self-employment taxes. All other tax deductions such as operating expenses, home office expense, mileage, meals, 401k plans, etc. are equally deductible with or without an S corporation.

Still not sure or not convinced? No problem… please check out Line 4 on Schedule 2 on your 2022 Form 1040 tax return. This number reflects the self-employment taxes paid on your business income.

We want to reduce this by 60 to 65%. If you see $15,000 then we can save $9,000 ($15,000 x 60%). This makes sense right? $100,000 in biz income would be $15,000. 8 to 10% of $100,000 is $9,000.

The previous table showed significant savings using a 40% salary without self-employed health insurance (SEHI). Again, we are only focused on the self-employment tax and payroll tax savings at this point. Section 199A from the Tax Cuts & Jobs Act of 2017 will be wormed into overall tax savings in a later chapter dedicated to qualified business income deduction. While reducing overall taxes and leveraging the pass-through tax deduction cannot be ignored, we are isolating payroll taxes to drive home a critical point.

Multiple Owners Savings

We have been discussing a one-person band in terms of savings and the flow of money. However, let’s briefly chat about the killer savings for a more than one owner situation. If the business had net ordinary business income after expenses and deductions of $150,000, and was split down the middle, each owner (two in this example) would pay nearly $7,000 in unnecessary self-employment taxes or $14,000 combined. A big number for sure, but consider the following.

WCG recently had a 9-person consulting firm being taxed as a partnership where each member earned about $125,000. The before and after analysis yielded a savings of just over $100,000 combined. Our fee for the S Corp administration (Vail Business Advisory Service) plus all the tax returns and tax planning was about $14,000 or approximately $1,550 per owner. And each owner saved about $12,000 in taxes and therefore pocketed $10,000 each.

The super sad part of this is that this entity was in place for over a decade with similar income and owners. Over a million dollars was wasted in unnecessary taxes. When you look at it that way, it makes you gulp a bit.

What happens when the business pays for your health insurance? Let’s find out how this can really soup up your tax savings.

By Jason Watson, CPA
Posted Monday, October 23, 2023

This is aimed at business owners where they no longer materially participate in the business activity, and as such they are now considered passive investors. Seems easy right, but why would you care? For two big reasons- first, if you have other non-deductible passive losses due to income limitations, such as those from a rental property, you can now have your passive income absorb these passive losses. This allows you to enjoy your tax benefits now rather than delaying the pleasure to future years. Yay!

Second, you might be able to only draw distributions from your business rather than earned income (i.e., reasonable shareholder salary) + distributions. This saves you several thousands of dollars in avoided Social Security and Medicare taxes. Every $10,000 in owner salary is about $1,500 in payroll taxes. Yay again!

The world is always trending towards harmony, so here are the passive business owner downsides. It is difficult to claim passive business owner given the material participation tests. The hardest one to overcome is #5. Here is a blurb from our Real Estate Professional webpage which is applicable to all business owners, not just real estate related-

5. You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

IRS Audit Techniques Guide (ATG): An activity is non-passive if the taxpayer would have been treated as materially participating in any 5 of the previous 10 years (whether or not consecutive). This test usually applies when a taxpayer “retires from material participation” but maintains an ownership interest in the activity. Yikes (emphasis added).

IRS Examination Techniques: Even if the taxpayer performs no services for a business currently, the examiner should inquire about involvement in prior years and review the returns to see if income or losses were treated as non-passive.

In other words, you need to look back for 10 years and if 5 of those years had material participation by you in the business activity (as defined by the IRS and Treasury Regs), then the IRS will disallow your passive claim. Could you start a brand-new business without the history? Perhaps, but this might be viewed as an end-around especially if the new business magically looks, walks, talks and smells like the old. Transitioning from material participation to passive is certainly tough!

By Jason Watson, CPA
Posted Monday, October 23, 2023

As we’ve discussed, the big benefit with an S Corp is the reduction of self-employment taxes. There are some other benefits that we touch on throughout our book, but they are also recapped here-

Section 199A Qualified Business Income Deduction

Once you hit the 32% marginal tax bracket, your QBI deduction either a) phases out if you are deemed to be a Specified Service Trade or Business (SSTB), or b) has a secondary test based on W-2 wages paid and / or qualified property. If you are a sole proprietor, an LLC or a partnership, and not taxed as an S corporation, you cannot pay owner wages. As such, an S Corp election might be necessary allow wages to be paid to the shareholders to resolve the QBI phaseout due to W-2 wages paid.

The quick Section 199A secondary test math goes like this- 20% of net business income (profits) or 50% of wages paid including employee wages, whichever is lower. 50% x $0 is $0, even in Canada.

Pass-Through Entity (PTE) Tax Deduction

Way back in 2017, the Tax Cuts and Jobs Act was passed with a lot of cool tax deductions like the Section 199A qualified business income deduction. But life is one big equalizer, and Congress wanted to limit state and local taxes (SALT) to $10,000. This means either state income taxes or real estate taxes, or both, were severely muted.

So! States got creative and created a state tax that was deducted on partnerships and S corporations tax returns (otherwise called pass-through entities) resulting in lower federal taxable income. This tax is in turn credited on the business owner’s individual tax return for the state. In other words, the business pays for the human’s state income taxes and this lowers the federal income associated with the business.

This also called the great SALT work-around. Cash is cash to a business owner whether it is spent by the business or the human.

Why is the PTE tax deduction considered an S corporation benefit? Your single-member LLC is not considered a pass-through entity, but if you slap an S Corp election on it, you suddenly have this deduction available to you (you can also add another member and tax your LLC as a partnership).

There are all kinds of rules, and not every business owner will benefit from the PTET deduction.

Lower Audit Rate Risk

Travel, meals and auto expenses are the big triggers for a Schedule C audit of your 1040 individual tax return. This is why the IRS calls them out specifically on the tax form. However, with an S Corp (and partnership or C corporation), these expenses are generally tucked away into other deductions. Home office is also tucked away.

S Corporations enjoy a 0.4% audit rate risk versus 3-5%. The best way to win an argument with the IRS is not having the conversation in the first place.

California’s LLC Fee

Without an S Corp election, California’s LLCs fee is based on gross receipts regardless of actual net income after expenses (profits) earned. With an S corporation, this tax is based on 1.5% of the net income (with an $800 minimum).

QSubs

A Qualified Subchapter S Subsidiary, also known as a QSub or QSSS, is simply an S corporation that’s owned by another S corporation. A QSub is treated as a subsidiary of the parent S corporation. Why do you care?

At times you want to merge two businesses, but the assets are immoveable (think of a Medicare certification or a specialized defense contract). You might need to S elect one before the combination because of certain rules with the merger. You might also want to combine gross receipts for the passive investment income test, or combine basis between stock and loan basis, or combine to release accumulated earnings and profit (AE&P). This is a bit technical, but just a little awareness as you move along in business life.

By Jason Watson, CPA
Posted Monday, October 23, 2023

To help fund the Affordable Care Act (Obamacare), an additional Medicare surtax is tacked on to your net investment income. Recall that as an S corporation owner, you are both employee and investor. When you trigger the high-income threshold for the Medicare surtax, then you could pay 3.8% (2.9% Medicare plus 0.9% surtax) on some portions of your income.

The tax is calculated by multiplying the 3.8% tax rate by the lower of the following two amounts:

• net investment income for the year; or

• modified adjusted gross income over a certain threshold amount ($200,000 for single filers and $250,000 for married filing jointly).

Again, whichever is lower (how nice of Congress?).

The IRS defines net investment income for the purposes of calculating the Medicare surtax as interest, dividends, capital gains, annuities, royalties, rents, and pass-through income from a passive business such as S Corps and partnerships. Yuck. Why did they have to pointedly name S corporations?

But! And this is a big but! Like a Mama June butt. If you materially participate in your S Corp this income is not included in the net investment income calculation. 99% of the small business owners out there who elect to be treated as an S Corp will also qualify as materially participating. In other words, your income is not considered passive which would otherwise be subject to the Net Investment Income Tax. Yeah baby!

Here is the laundry list the IRS uses for testing material participation-

To materially participate in a business for a particular year, the shareholder must meet one of the following seven tests discussed in Temporary Regulations Section 1.469-5T(a)–

• The shareholder participated in the activity for more than 500 hours during the year;

• The shareholder’s participation in the activity constituted substantially all the participation of all individuals in the activity;

• The shareholder participated for more than 100 hours in the activity, and the shareholder’s hours were not less than those of any other participant in the activity;

• The activity is a significant participation activity for the year, and the shareholder’s aggregate participation in all significant participation activities exceeded 500 hours;

• The shareholder materially participated in the activity for any five of the past 10 years;

• The activity is a personal services activity where the shareholder materially participated in the activity for any three years preceding the tax year; or

• Based on all the facts and circumstances, the shareholder participated in the activity on a regular, continuous, and substantial basis.

This list is an “or” list, therefore you only need to fit into one of the buckets to trigger the material participation designation. Interestingly, these regulations are titled Temporary Regulations but they have been around for a very long time. Like forever. Maybe even forever and ever.

Material participation is a common theme with the IRS, and in some respects, it changes the color of money similar to an S Corp election. A silent investor in an S corporation will have passive income and might be subject to Medicare surtax on that income. That same investor now materially participates, and the same income is now considered non-passive (or quasi-earned but without self-employment taxes) and is sheltered from the Medicare surtax.

While we are here, let’s chat about being a passive business owner.

By Jason Watson, CPA
Posted Monday, October 23, 2023

One of the biggest pushes into the S Corp world is when your employer decides to convert you from W-2 to 1099. You are fired on Friday and brought back on Monday as a contractor. Now what?

To refresh your memory, when you are paid a W-2 salary your employer pays for half of the Social Security and Medicare taxes associated with your income. Conversely when you are paid as a 1099 contractor, you pay both halves of the Social Security and Medicare tax.

Another nice feature of being paid a W-2 salary is the built-in budgeting since your taxes are taken out before the direct deposit into your checking account. On the other hand, 1099 income is raw- just a big ol’ fat check ready to spend.

Businesses like to have contractors versus employees since it cuts down on cost and offers more flexibility. Some businesses can easily exceed a factor of 1.5 for a fully burdened labor rate. For example, if you are being paid a $100,000 salary, the cost to the employer could be $150,000 after you factor in payroll taxes, 401k contributions, pension funding, health insurance, vacations and sick pay, office resources, etc. This would be a factor of 1.5.

Another benefit of deploying contractors is when a business needs to shrink, it simply ends the contract or reduces it dramatically without much hoopla. If Northrop Grumman laid off 10,000 workers there would be congressional hearings. If they cancel 10,000 contracts with sub-contractors, no one pays any attention to it.

Some employers, such as Verizon, have recently gotten in trouble by converting too many W-2 employees into 1099 contractors. The IRS and several states see it as an end-around. Many one-person S corporations are probably disguised W-2 employees so this is a sensitive subject.

Regardless, when entertaining being converted from W-2 to 1099, consider the fully burdened labor rate of your employer. If you were making $100,000, you really need to make at least $130,000 or more to come out ahead. You win, they win.

Don’t forget that as a 1099 contractor you now can rifle a bunch of expenses through your business that were otherwise limited or not allowed. Wait! What? Let’s take mileage as an example. If you are paid as a W-2 employee, you cannot deduct mileage expenses since 2017. But if you are paid as a contractor, your business can either own the car and deduct actual expenses, deduct mileage (Schedule c) or reimburse you for mileage (S Corp). Not just one option, baby, but a 3-pack of ‘em.

Being converted from a W-2 employee to a contractor is risky since the connective tissue is reduced dramatically, but generally it is a good thing since it puts you in a better tax position (and you might actually make more money). However, don’t leak that out during negotiations.

Lastly, create an LLC and tax it as an S corporation, or at least consider it. In another chapter we’ll review some of the reasons an S Corp election is not good. In yet another chapter, we take the W-2 Converted to 1099 one step further when considering a reasonable shareholder salary.

By Jason Watson, CPA
Posted Monday, October 23, 2023

[wcg-scorp-package]

No more shameless promotion… at least for a while.

By Jason Watson, CPA
Posted Monday, October 23, 2023

When your S corporation pays for your self-employed health insurance (SEHI) and dental / vision premiums, including coverage for your family, that amount is added to Box 1 Wages on your W-2. So, your income is artificially increased by the annual amount of premiums. However, there are two huge concepts you need to love and embrace.

First, Box 3 Social Security Wages and Box 5 Medicare Wages do not get increased by the amount of premiums paid. Here is a silly looking, but illustrative W-2.

Box 1 Wages	50,000		Box 2 Federal Tax Withholdings	21,735
Box 3 Social Security Wages	40,000		Box 4 SS Withholdings	2,480
Box 5 Medicare Wages	40,000		Box 6 Medicare Withholdings	580
Box 16 State Wages	50,000		Box 17 State Tax Withholdings	4,347

Don’t get tweaked on the federal and state tax withholdings. We’ll explain that in a later chapter.

Spoiler alert: When WCG processes shareholder payroll, we increase income tax withholdings to help budget for the K-1 income that is combined with your W-2 income on your individual tax return). This allows you to land on tax neutrality as a household without needing separate estimated tax payments. Beauty!

Back to the W-2. Your focus should be on Box 3 and Box 5- these are the boxes that we want to reduce to the best of our abilities and with reasonableness.

Subsequently Box 4 and Box 6 is the calculation of the Social Security and Medicare taxes based on the amounts in Box 3 and Box 5. As you can see, your compensation is $50,000 but only $40,000 is being used to compute Social Security and Medicare taxes. Why is this? Some taxable fringe benefits, such as health care benefits (self-employed health insurance premiums and HSA contributions), are only added to Box 1 Wages, and not Box 3 or Box 5. Boom!

Explained another way; if we all decide that $50,000 is reasonable shareholder salary, and your self-employed health insurance premiums are $10,000, then only $40,000 is ran through payroll. But, the $40,000 and the $10,000 are combined to reflect total shareholder salary.

How does this translate to the corporate tax return? Line 7 of Form 1120S is “Compensation of officers” and the $50,000 in Box 1 above would be entered there (we’ll chat about the effects of solo 401k plan deferrals in a bit). Line 21 of Form 1120S is “Ordinary business income.” Line 7 as compared to Line 21 is one of the ways the IRS will consider a challenge of your S corporation with respect to reasonable shareholder salary (the IRS also looks at your K-1, specifically Box 16 Code D, as compared to your W-2, both connected by your Social Security Number).

Got it? Good. Next concept.

The second concept is that self-employed health insurance (SEHI) premiums are effectively deducted on Line 7 of Form 1120S as Officer Compensation. Therefore, the salary paid to the shareholders plus health insurance directly reduces Line 21 on Form 1120S which is your taxable ordinary income generated by the S corporation.

However, your W-2 shows $50,000 in taxable wages and this will appear on Line 1 of page 1 on your Form 1040. Hmmm… how does that work? We know what you are thinking- you are paying income taxes on the full $50,000 since the W-2 shows $50,000 but you were paid $40,000. Where are the tax savings?

This concern would be true except that you are considered self-employed as a greater than 2% shareholder, and therefore the health insurance premiums are deducted on Line 16 on Schedule 1 of your Form 1040 as an adjustment to income. This is a dollar-for-dollar reduction in your gross income to arrive at your adjusted gross income (AGI) on Line 8b.

Just to reiterate- the deduction and subsequent tax benefit of self-employed health insurance (SEHI) is done on the S corporation tax return. The deduction appears on your individual tax return, but it is a net zero as we’ve illustrated above (we accountants call this an in and out… income comes in, but is adjusted out for a net zero effect).

Said in another way; salary and health insurance end up as Officer Compensation and are deducted together on the S Corp tax return. This amount appears again on your individual tax return, but you get a “reduction” for the health insurance component. Deduction on business return. Net zero on individual tax return.

If this doesn’t resonate quite yet, don’t worry. However, we have seen this screwed up several times when clients run their own payroll and / or prepare their own individual tax returns. Be aware and know that you should have a Line 16 entry on Schedule 1 of your Form 1040 if you are paying self-employed health insurance premiums.

To make things even stranger, a lot of taxpaying citizens are accustomed to health insurance either being 100% provided by their employer or a payroll deduction in some fashion. This works well for employees since the payroll deduction is usually pre-tax and therefore the tax benefit is immediate However, for the employee turned S Corp owner, this can be a small derailment during the transition.

To recap- we have an artificial increase in salary by the amount of SEHI and our reasonable shareholder salary testing is improved, but Social Security and Medicare taxes are computed on a lessor amount. Winner winner chicken dinner!

Another way to view your self-employment health insurance is that it is costing you about 60 cents on the dollar. 15 cents in less payroll taxes and another 25 cents in income tax savings. This might not make you feel better given the massive cost of health insurance, but here it is just the same.

There are more examples of this stuff in a later chapter dedicated to reasonable shareholder salary. Also, the handling of self-employed health insurance in this manner is encouraged by the IRS as outlined in Fact Sheet 2008-25.

Here is the blurb if you can’t get enough-

The health and accident insurance premiums paid on behalf of the greater than 2 percent S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee’s Form W-2. They are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. Therefore, this additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but would not be included in Boxes 3 or 5 of Form W-2.

A 2-percent shareholder-employee is eligible for an AGI deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation.   Previously, “established by the S corporation” meant that the medical care coverage had to be in the name of the S corporation.

In Notice 2008-1, the IRS stated that if the medical coverage plan is in the name of the 2percent shareholder and not in the name of the S corporation, a medical care plan can be considered to be established by the S corporation if: the S corporation either paid or reimbursed the 2percent shareholder for the premiums and reported the premium payment or reimbursement as wages on the 2percent shareholder’s Form W-2.

Payments of the health and accident insurance premiums on behalf of the shareholder may be further identified in Box 14 (Other) of the Form W-2. Schedule K-1 (Form 1120S) and Form 1099 should not be used as an alternative to the Form W-2 to report this additional compensation.

That was IRS Fact Sheet 2008-25 which can be downloaded here-

wcginc.com/8247

Big Alert: If you have access to health insurance through your spouse, you generally cannot do two things. You cannot get your own health insurance coverage and have it be a tax deduction for the business. You also cannot consider the additional premium paid by your spouse as a reimbursement and therefore deduction for the business (typically this is already tax-advantaged since it deducted pre-tax by your spouse on their paycheck).

Here is a summary of the savings assuming a 40% salary and a $10,000 annual health insurance premium.

40% Reasonable Salary, With Health Insurance

The following table highlights the significant savings when factoring self-employed health insurance into the reasonable salary calculations.

Income	Total SE Tax	Salary	Total Payroll Tax	Delta	Delta%
30,000	4,239	2,000	306	3,933	13.1%
50,000	7,065	10,000	1,530	5,535	11.1%
75,000	10,597	20,000	3,060	7,537	10.0%
100,000	14,130	30,000	4,590	9,540	9.5%
150,000	18,711	50,000	7,650	11,061	7.4%
200,000	20,050	70,000	10,710	9,340	4.7%
300,000	22,972	110,000	16,830	6,142	2.0%
500,000	29,991	190,000	20,204	9,787	2.0%

35% Reasonable Salary, Without Health Insurance

As mentioned, the previous illustrations are based on a reasonable salary that was 40% of the net ordinary business income after expenses and deductions. If your reasonable S Corp salary is less than this, your savings increase. For grins, the table below shows the results and subsequent savings using a 35% reasonable salary figure. Check out the $150,000 figure! $10k in savings.

Income	Total SE Tax	Salary	Total Payroll Tax	Delta	Delta%
30,000	4,239	10,500	1,607	2,632	8.8%
50,000	7,065	17,500	2,678	4,387	8.8%
75,000	10,597	26,250	4,016	6,581	8.8%
100,000	14,130	35,000	5,355	8,775	8.8%
150,000	18,711	52,500	8,033	10,679	7.1%
200,000	20,050	70,000	10,710	9,340	4.7%
300,000	22,972	105,000	16,065	6,907	2.3%
500,000	29,991	175,000	19,769	10,222	2.0%

The salary calculation part of running an S Corp is one of the biggest challenges, but it also allows for most wiggle room for argument if necessary. Our chapter on S Corp salary will touch on the various tools we use to determine a reasonable shareholder salary including-

• IRS Revenue Ruling 74-44

• IRS Fact Sheet 2008-25

• Tax Court Cases

• Bureau of Labor Statistics / Risk Management Association Data

• RCReports

• Rules of Thumb (Biz Valuation, 1/3 1/3 1/3)

Here is some initial food for thought from a 2013 Tax Court case-

Sean McAlary Ltd. Inc. v. Commissioner, TC Summary Opinion 2013-62– the IRS hired a valuation expert to determine that a real estate agent should have been paid $100,755 salary out of his S Corp’s net income of $231,454. Not bad. He still took home over $130,000 in K-1 income and avoided some self-employment taxes. The valuation expert had used Bureau of Labor Statistics data to determine the average salary for real estate agents in the taxpayer’s zip code.

Here is the entire Tax Court summary opinion-

wcginc.com/8244

Please don’t be that guy who extrapolates or basically twists the previous Tax Court case into something else. BLS data is only one aspect of determining a reasonable salary. As mentioned, there is more on the salary stuff in a later chapter and pinning your entire argument on BLS data might leave money on the table.

Until then, consider the following summary which outlines the savings using various net ordinary business income after expenses and deductions, and reasonable shareholder salaries paid (including one with self-employed health insurance)-

Net Biz Income	40% Salary No Health Ins.	40% Salary $10k Health Ins.	35% Salary No Health Ins.
30,000	2,403	3,933	2,632
50,000	4,005	5,535	4,387
75,000	6,007	7,537	6,581
100,000	8,010	9,540	8,775
150,000	9,531	11,061	10,679
200,000	7,810	9,340	9,340
300,000	4,798	6,142	6,907
500,000	9,497	9,787	10,222

Good stuff!

Why are we belaboring the heck out of this? In other words, does payroll really need to be dialed in this tightly? Consider that paying a salary which is $10,000 too high will cost you $1,530 in unnecessary payroll taxes. Read that again. If you paid yourself $100,000 when a reasonable salary could have been $80,000, you paid $3,060 too much in payroll taxes. What would you rather spend $3,060 on? Lots!

So, payroll calculations need to be just a bit tighter than bar napkin quality and just a hair below NASA precision.