(A 2-percent shareholder is someone who owns more than 2 percent of the outstanding stock of the corporation or stock possessing more than 2 percent of the total combined voting power of all stock of the corporation.)
The 60/40 rule is a simple approach that helps S corporation owners determine a reasonable salary for themselves. Using this formula, they divide their business income into two parts, with 60% designated as salary and 40% paid as shareholder distributions.
Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income.
Let's start with the S corporation: An S corporation may deduct the health insurance and accident insurance premiums it pays for 2% shareholders, spouses, and their dependents. But to do so, it must report the premiums as wages on the respective shareholder's W-2.
HUSBAND AND WIFE WILL BE TREATED AS SOLE SHAREHOLDERS OF S CORPORATION STOCK HELD IN TRUST. Tax Notes.
In short, you can ensure you don't incur the cost of those additional payroll taxes if you offer insurance to all employees. If your S Corp only provides insurance for owners, the premiums are subject to both income and payroll taxes.
As a pass-through entity, one of the biggest tax advantages of the S corp business structure is that it avoids double-taxation, which means S corps don't have to pay taxes at the federal level the way C corps do. Instead, S corp profits are only taxed once, on the personal tax returns of individual shareholders.
Shareholders may only be individuals, certain trusts, estates, and certain exempt organizations (such as a 501(c)(3) nonprofit). Shareholders may not be partnerships or corporations.
Some unique income tax rules apply to S corporations regarding compensation and fringe benefits paid to shareholders who own greater than 2% of the corporation. Under these S corp income tax rules, a greater than 2% shareholder is taxed as a partner in a partnership for fringe benefits received.
The right time to convert your LLC to S-Corp
From a tax perspective, it makes sense to convert an LLC into an S-Corp, when the self-employment tax exceeds the tax burden faced by the S-Corp. In general, with around $40,000 net income you should consider converting to S-Corp.
The premise behind the 70/30 rule is that historically, economic output is made up of about 70 percent returns to labor and 30 percent returns to capital, so that ratio should also apply to the income of pass through business owners.
The direct answer to whether an S Corp can pay a shareholder's mortgage is no. Personal expenses, including mortgage payments, cannot be directly paid by the corporation without significant tax implications and potential violations of IRS regulations.
Distributions you receive as a shareholder of an S corporation do not constitute earned income for retirement plan purposes (see IRC Sections 401(c)(1) and 1402(a)(2)).
Life insurance premiums are only deductible if the S corporation offers life insurance as an employee benefit. The employee will not be taxed on these premiums because the premiums will be excluded from the wages section on the employee's W-2.
An income item will increase stock basis while a loss, deduction, or distribution will decrease stock basis.
An S corporation is a corporation that elects to be taxed as a pass-through entity. Income, losses, deductions, and credits flow through to the shareholders, partners or members. They then report these items on their personal tax return. IRS approval is required for the S election status.
Per IRC section 1377(a)(1), items of income, gain, loss, deduction, or credit are allocated to the shareholder on a per-share, per-day basis. S Corporation items can't be specifically allocated to shareholders.
The 60/40 Rule S Corp Approach: A Closer Look
The most common strategy used to specify the amount of earnings paid in salary and distributions is the 60-40 approach. Under this strategy, the owner would pay themself 60% of earnings as a salary and the other 40% as distributions.
And if the IRS and/or the courts find that your S corporation did not pay you reasonable compensation, you can experience a new surprise salary, payroll taxes, and penalties. This will make your bad year worse.
The more money you pay yourself as a distribution, the more Social Security and Medicare tax you'll save when you run an S Corp. Likewise, the more profit your business earns, the more you'll save. You need to earn at least $40,000 in profit for an S Corp to make sense, though.
Money you make working for an employer or that you pay yourself as a reasonable salary are wages and count toward your benefits. Things like investment income or distributions from your S Corp do not. This means that the S Corp tax structure will reduce your Social Security benefit somewhat.
The IRS allows S-corporations to pay for (and deduct) the medical expenses of their shareholders, but only under certain stipulations. First, the employee or owner must be a more-than-two-percent shareholder of the corporation.
You may or may not have heard of the S Corp Salary 60/40 rule. The guideline encourages setting reasonable compensation between 60% and 40% of the business's net profits. The IRS does not set this guideline. It should not be relied on as the only factor for deciding S corporation reasonable compensation.