3 Money Making Tax Deductions You Aren’t Taking Advantage Of.
Before we jump into this mind-blowing topic: How to milk your S corp tax-free. I want to quickly go through what an S Corp is and how it works.
What is an S Corporation?
An S Corporation is a business entity that has elected to pass its corporate income, losses, credits, and deductions to its shareholder(s). S Corps don’t pay income tax. Instead, the company’s individual shareholders split up the income amongst each other and report it on their own personal tax returns.
Unlike a sole proprietorship, S corporations are legally separate entities from its owner. It provides a layer of protection for your personal assets in the event your business can’t pay its debts or gets sued.
In simpler terms, It’s a way of forming a business so that it avoids double taxation – as compared to C-Corporations. S Corporations have all the advantages of a corporate business structure while allowing the profits and losses to pass through to the shareholder(s), thus avoiding double taxation
There are a lot of pros when it comes to structuring your business as an S corporation. And this is the most popular entity when it comes to small businesses. If you didn’t know, the term S corporation means, small business corporation.
With that being said, it’s important to know what entity you have your business registered as. Most people think they automatically have their business registered as an S Corporation. But when you form a corporation in the United States. You’re automatically a C corporation – not an S corporation.
Unless you’ve filed form 2553 to elect to change your C corporation to an S corporation, then you might be making this mistake. Double-check with your tax planner to make sure you’ve filed form 2553 to become an S corp.
How to pay yourself properly in an S corporation.
The aim of an S corporation is to pay less in taxes, right? So how exactly do you go about paying yourself while staying out of trouble with the IRS?
First things first, you need to pay yourself a reasonable compensation. The keyword here is reasonable. The IRS requires S corporation owners to be paid a reasonable compensation. Basically, it needs to be comparable to what other businesses are paying within your industry.
There can be pricey consequences if the IRS determines that a shareholder’s wage is not reasonable. You could be penalized for neglecting to withhold and deposit employment taxes. And be required to back pay the taxes that were not reported.
Next, once you max out your reasonable compensation from your S Corporation, you may now take out distributions that are NOT taxable since S Corporation is a pass-through entity. Again, this means that it passes its income/losses to its shareholders.
In a nutshell …
- You don’t want to be taking a huge salary, but pay yourself a reasonable compensation.
- You pay payroll taxes on your salary, like any other employee.
- You don’t pay payroll taxes on any dividend distributions from your S corp.
Payroll taxes are 15.3%! So any income you take as a distribution rather than a salary saves you that cost in taxes.
Now that we’ve reviewed the basics of an s corp. Let’s talk about tax deductions and tax planning.
What is a tax deduction and how does it work?
A tax deduction lowers your taxable income and therefore reduces the amount of taxes you pay.
The first rule of thumb for tax deductions, any expenses that directly or indirectly relates to your business is a tax deduction. As long as it is ordinary and necessary for your business.
But, some tax deductions aren’t so black and white. And you could be missing out on deductions that a tax planner is able to legally create for you. I can guarantee you, that your tax preparer will not know how to take advantage of these tax strategies. So if you haven’t already it’s time to get a tax planner on your team.
The first step to milking your S corp tax-free is drawing up an accountable plan.
What is an accountable plan?
An accountable plan is a document that states how an employee is reimbursed for expenses and/or receives an allowance to cover expenses.
These expenses must be business-related, of course. These can include (but are not limited to) expenses related to:
Businesses must have an accountable plan so employees don’t get taxed on reimbursed expenses. All money that is reimbursed by a company should be done on a W2 – which is subject to payroll tax unless you have an accountable plan in place.
An accountable plan is super simple to put in place. No, you don’t need to submit a written plan to the IRS. But you do need to prove that you have defined your terms for reimbursing employee expenses.
This can easily be put together in writing with the help of a tax planner.
Let’s dive into our first juicy deduction using the accountable plan…
Strategy #1: Home Office Deduction.
The work from home erra is far from over. And it’s important for your bottom line to know how to take advantage of all the deductions available to you.
It’s essential that the terms of your home office deduction are outlined in your accountable plan. Additionally, there are two key requirements that you must meet to claim the Home Office Deduction.
1.Regular and exclusive use.
You must regularly use and allocate part of your home for conducting business. You’re not able to deduct your entire house. But, if you have a designated room for your home office then you can take a home office deduction for that room.
2.Principal place of your business.
Even if you carry out business at another location. You can deduct your expenses for part of your home that is exclusively used for business.
You can also deduct expenses for a separate free-standing structure. Such as a studio, garage, or barn, if you use it exclusively and regularly for your business. And the structure does not have to be your principal place of business.
How does the home office deduction work?
Your business has to reimburse you personally every month for all your home office-related expenses.
This is done exactly the same way you would reimburse your employees for business-related expenses. You save the receipts and your business will cut you a check for those expenses. And most importantly when your business reimburses you, you do not pick this up as income.
These deductions include, but are not limited to:
- Mortgage changes
- Property tax
- HOA Fees
- Cleaning fees
- Any repairs that affect your home office
The home office deduction is a great way to score extra tax savings that you aren’t taking advantage of. I recommend getting together with your tax planner to make the most of this tax deduction.
Strategy #2: Putting your Kids on Payroll.
Putting your kids on payroll? Yes, as crazy as that sounds, you can hire your kids… for more than tax savings.
You can teach them:
- The ropes of your business.
- How entrepreneurship works.
- Help them develop strong work ethics.
All while earning tax-free income!
Let me teach you how to hire your kids the smart way.
Each of your children can be employed by your business and makeup to $12,950 (2022) tax-free. As a matter of fact, anyone in the United States does not pay taxes on a reported income of $12,950 or less.
Your business will be able to take the deduction, thus decreasing your tax liability. And your child will not pay any federal taxes.
Yes, you will still have to pay payroll tax, but the overall tax savings still outweigh the cost.
There is no age requirement when hiring your kids. But, one thing to remember: it needs to make sense. Don’t hire your 5-year-old son to take care of the business finances. #1 it’s a terrible idea because he is just learning basic math and #2 it will not fly with the IRS.
For example, a client of ours hired their 12-year-old daughter to help out with social media management. She’s on Instagram and Facebook all day, every day. So you could say it was a job match made in heaven.
But don’t worry, there are endless skills for your children to learn in your business. CRM management, filing, cleaning, sales … I mean who would turn down a deal from a cute kid?
Strategy #3: Section 127 – Tuition Reimbursement.
Section 127 states that employers are allowed to provide tax-free payments up to $5,250 per year to their employees. The following education expenses are eligible to be reimbursed:
- Educational fees
Up until 2020 student loans were not eligible to be reimbursed under Section 127. But, The Coronavirus Aid, Relief, and Economic Security (CARES) Act provides an expansion to Section 127. The expansion allows employers to include student loans for the years 2020-2025.
Section 127 and the expansion of The CARES act serve as another juicy tax deduction for your S corporation. And it’s not subject to additional taxation for your employees.
Before you start providing these reimbursements. It’s important to understand the requirements of Section 127. And always consult your tax planner before you put anything new in place.
1.The employer must have a written educational assistance plan.
Like how you have a written accountable plan, you need to have a written plan that outlines terms of your EAP. There are a few tax variables to consider. We recommend consulting with your tax planner to help with this.
2.No discrimination towards some employees
The terms of your written educational assistance plan can’t discriminate against some employees. You must offer it to all of them. Meaning, you can’t favor highly compensated employees. Or only put it in place for your children. With that being said, you can state terms that say you don’t want to include student loans. Only current educational expenses, or vice versa.
3.An employee may not receive more than $5,250.
If an employee has multiple employers and they’re both offering this benefit. They’re only eligible to receive a total of $5,250 from all employers.
4.No choice of cash benefits
An employee can’t be given the choice of receiving taxable compensation or education assistance. The IRS does not consider education assistance as part of taxable income. This would mean that the employee would have to pay taxes on something that is not taxable in the first place.
5.Spouses or dependents of employees are not eligible.
Only employees that work for the business are eligible to receive this reimbursement.
You must notify any employees who are eligible for the educational assistance program. But, you don’t have to provide a special form or document. Typically employers will use their written education assistance plan. Or some companies use this section as an incentive for making it part of their benefits package.
You’re also able to do this with your own children. Remember how we touched on hiring your kids into your business? Well, if your child is over 21 and fits the terms for your written education assistance plan. Then they can take full advantage of the $5,250 reimbursement.
Therefore, once your kids hit the age of 21. You can hire and pay them $12,950 that’s tax-free. And pay them an additional $5,250 that’s free of payroll and income taxes.
This is what I call a prime example of milking your S corporation for tax benefits.
How to take full advantage of all these tax deductions?
If you want to take full advantage of these tax deductions and significantly reduce your tax liability. And I mean, significantly reduce your tax liability … then you need to get a tax planner.
There’s a big difference between a tax planner and a tax preparer. Almost every business owner has a tax preparer to file their year-end taxes. But your tax preparer won’t tell you about these tax-saving strategies.
Tax preparation is only about putting the right numbers in the right boxes. But if you really want to minimize your tax liability and pay yourself through your tax savings, then you need tax planning.
If you’re curious about how the strategies can fit into your business, tap here to book a free tax strategy session.