I hope you haven’t forgotten about the big changes that are coming down the pike at the end of this calendar year, as it relates to overtime, salaries, etc.
[If you haven’t been paying attention, the FLSA exemption limits are changing, and many business owners will need to have a different compensation strategy if they want to remain within compliance — which, you know, is kind of usually a good idea ;).]
I’ve had a few good conversations with clients and friends about it, and (as usual) it’s smart to be thinking ahead for what you can do.
Some options include converting some of your employees into independent contractors. That is a possibility — but ONLY if rigorous standards are adhered to, and it isn’t being done primarily as a tax dodge.
Believe me, you don’t want to get into hot water on that front.
That’s one of a few possible tax or regulatory traps that you might fall into, unless you’re careful.
Allow me to explain…
Long Island and Stamford Small Business Tax Traps
“Trouble shared is trouble halved.” -Lee Iacocca
With the federal and state governments continually looking for more ways to add to their revenue (rather than cutting their expenses), it’s always smart to be on the lookout for traps that are being set for you.
And there are two big ones (among others) that can hit small business owners, unless they’re careful…
The S-Corp Salary/Basis Traps
An S Corp is a pass-through entity. That means the income and losses of the company pass through to your personal return. The entity itself files a tax return, but doesn’t actually pay tax (except a state tax in a couple of states).
The reason why S Corps are usually so much better for business is that the taxable income of other business entities are not just subject to federal and state income tax, but also subject to self-employment tax of 15.3%. That is unless the business operates in an S Corporation.
You can take cash out of your S Corporation through salary and through distributions. Distributions are not subject to self-employment tax or payroll tax. Salary is subject to payroll tax.
Most of the time, an S Corp owner wants to take the smallest amount of salary legally possible. That reduces the payroll tax.
And this is where the problem comes in:
S-Corp Trap #1: Owner not taking enough salary.
I know some business owners who tempt fate and only take about 20% of their overall income as salary, and the rest is from distributions. There are no hard and fast rules, except that the salary must be “reasonable” as compared to similar positions in other similar companies.
Many companies adopt a 60/40 split (60% salary, 40% distribution), others adopt a 40/60 … it really depends on a variety of factors. But if you don’t take enough, you risk the IRS choosing to “recharacterize” your distributions as salary.
Which, of course, would leave you with a big fat payroll tax bill. And this is why many small business owners end up in IRS Debt Hell.
But the other small business tax trap can result in you paying TOO MUCH tax, rather than too little:
S-Corp Trap #2: Paying income tax on an unprofitable business.
Let’s say you have a Long Island and Stamford business owner named Michael, who owns a couple restaurants. Michael had an income of about $300,000 per year, before his salary. He took out a salary of $200K per year each, so he ended up with salary total of $400,000 and a loss in the flow through company of $100,000 ($300K – $400K).
Now here is the problem.
An S Corporation has two kinds of basis: equity basis and stock basis. You have to have enough in one or the other to be able to deduct losses.
Michael didn’t have it.
So, he made $300,000 in taxable income, paid tax on $400,000 of salary and could not deduct the S Corp loss. So he paid tax on $100,000 that he hadn’t actually been able to enjoy as income.
This can be fixed, but it’s a process that requires some doing.
Which, of course, is what we’re here for.
Let us see the traps in advance, so you don’t fall into them.
I’m grateful for our chance to serve you and your business — and we are dedicated to its success, in every measure.
Feel very free forward this article to a Long Island and Stamford business associate or client you know who could benefit from our assistance — or simply send them our way?These particular articles usually relate to business strategy because, as you know, we are Profitability Consultants also specializing in tax preparation and planning for Long Island and Stamford families and business owners. And we always make room for referrals from trusted sources like you.
Michael J. Kessler, CPA
PS–Join us for our show Business Profits In The Real World Saturday afternoons at 4 on 103.9FM WRCN where we bring you Long Island and The New York-Metro’s most successful business owners sharing how you too can bring your business to among the most profitable in your industry. No radio? No problem! Listen live at LINewsRadio.com – or can’t listen live? Hear our past shows atMichaelKesslerCPA.com