[Editor's Note: Today's Platinum Level Scholarship Sponsored post comes from Alexis Gallati, EA, MBA, MS Tax, CTP, and Founder/Lead Tax Strategist of Cerebral Tax Advisors. Alexis grew up in a family of physicians, married a physician, and focuses her expertise on tax planning and maintenance for physicians. Thank you for supporting those who make the WCI Scholarship possible! The sponsored posts this year are top-notch, including this one.]
Regardless of the kind of operation or business you run today, you are probably always looking for ways to lower your tax burden. It only makes sense—we all want to save money where possible, right?
For healthcare professionals with S-corps, you are aware your profit is passed to you through a Schedule K-1 and taxed at the individual level instead of being taxed at the S-corp level. As a means to protect your liability while still offering the benefits of personal taxation, S-corp status saves you from paying medicare and social security taxes (aka self-employment taxes) on distributions.
This article covers S-corps with an owner/employee and/or spouse. If you have employees other than your spouse or children, the rules become a bit more complicated (that is for a future article). We’re here to clear up any confusion for you. Let’s look further into how you can slash your S-corp taxes today.
Slash S-Corp Taxes for Good
#1 Reduce Owner’s Wages
From my experience, I estimate that S-corp owners can slash personal payroll taxes by $8,000-$20,000 a year by lowering their inflated salaries. Lowering your salary allows the owner to take their remaining S-corp earnings as distributions which aren’t subject to self-employment tax. However, you need to make sure you don’t drop the salary below what the IRS considers “reasonable compensation”, as a yearly income of menial means will flag your return for potential audit. It’s also important to never take a distribution unless you have a salary.
How can you decide what that sweet spot is without violating the law? The first step is to find reliable stats regarding the wages for your job in your area of the country. Remember, most physicians who own their own businesses “wear many hats” and not only perform the work as a physician but also the bookkeeper, administrative assistant, travel agent, and even the janitor! You have to allocate your time between all these jobs and apply the appropriate hourly wage rate for each job to come up with your salary. Be sure to document your analysis in corporate minutes so that you can make a case if the IRS flags your justified salary.
#2 Cover Owner’s Health Insurance Premiums
Most healthcare business owners don’t realize you need to run your health insurance through your S-corp to deduct it. Next, for the owner or employee that owns more than 2% of the company, an S-corp can establish a health insurance plan in one of two ways: the S-corp pays the premium for the owner or family, or the S-corp reimburses the owner for the premiums.
Your S-corp’s health insurance plan can cover you and your spouse, dependents, and children under the age of 27. But, you only qualify for this kind of deduction if you go through these IRS-required steps:
- Make sure the S-corp pays for your insurance premiums directly or through reimbursement.
- The S-corp needs to include the health insurance as wages on your W-2, and
- Deduct the cost of the premiums using the self-employed health insurance deduction on Form 1040.
It’s important to note, you are unable to take this deduction if you and your spouse are eligible for health insurance through your spouse’s employer. In addition, the insurance premiums cannot exceed the amount of your S-corp salary.
#3 Employ Your Child
If you employ your children in your S-corp, although you must pay payroll taxes on the child’s wages, you can shift income from your higher tax bracket to your child’s lower tax bracket while saving for their future or covering current costs, like private school tuition.
In fact, each child can earn up to $12,200 in 2019 without paying any federal income taxes at all while your S-corp receives a deduction for their wages. This is an excellent opportunity to use your child’s earned income towards your child’s retirement savings, college savings, or to pay for current private schooling. In fact, if they are able to earn more than $12,200, you can pay them an extra $6,000, take a traditional IRA deduction, and then roll it over to a Roth IRA – all not being subject to income tax!
As an S-corp, your child’s wages are still subject to social security and medicare tax but starting a retirement account early allows for tax-free growth of those contributions. However, it is important to note that you have to have legitimate work for your child to perform in order for them to earn their wages and document it properly otherwise your child’s wage deduction may be denied under audit.
[Editor's Note: If your sole proprietorship hires your children, their wages are not subject to payroll taxes. There's a reason that my kids are not directly employed by The White Coat Investor, LLC but a separate company WCI contracts with.]
#4 Sell Your Home to Your S-Corp
If you are thinking about turning your home into a rental property in the near future, before you do that, consider this arrangement. If you sell your home to your S-corp, you can avoid taxes on the sale with home-sale exclusion of $250,000 gain (which can be $500,000 if you are married). This arrangement will also increase the rental property’s depreciable basis, which lays the foundation for greater depreciation deductions in the future.
Let’s look at an example. Let’s say you and your spouse bought your home 20-years ago for $250,000. Since you did not oversee any notable improvements, the basis in your home at the time of sale is still $250,000. If you sell the home to your S-corp for the current market rate of $750,000, you have a gain of $500,000. However, as a married couple, you can use your $500,000 home-sale exclusion to avoid taxes on the $500,000 gain.
If you converted your home to a rental without selling it to your S-corp, you could lose your homestead exemption depending on when you sell it. Selling the home to your S-corp increases the basis in the rental property. So, in our example above, the new depreciable basis of the property is $750,000 and the depreciation deduction flows through to your individual tax return from the S-corp.
Things to Consider
Do consider if selling your home to your S-corp will cause your property taxes to increase. In most cases, your property tax appraisal may already be around the fair market value of your home at the time of sale to your S-corp. Also, the benefits of the home-sale exclusion and the increased depreciation basis outweighs any increase in property taxes.
Lastly, since no one reports related-party sales to the IRS on tax returns, you don’t need to worry about the IRS flagging you for this one. Of course, under the law, you must treat the sale to your S-corp as a related-party sale, which means you should create evidence, such as appraisals, use of attorneys or title company, inspection on the home, etc. that shows you followed the rules for a sale to a related party.
#5 Home-Office Expenses
Traditional tax deduction strategies always include looking for personal expenses that can be deducted against business earnings. The same holds true for S-corps. When the S-corp reimburses the owner for home office expenses, the reimbursement is a deduction for the S-corp. The result? Part of the owner’s living expenses become tax-free. Let’s dive a little deeper.
Things to Consider
Did you know that renting the office to your S-corp will provide you with a benefit of zero dollars? The S-corp deducts the rent paid to you. If you include the rent in your taxable income on your personal tax return, the current tax code does not allow you to claim tax deductions against the rental income. In addition, you cannot use Form 2106 to deduct unreimbursed expenses on your Schedule A anymore assuming you qualified over the 2% AGI limitation in the first place.
Therefore, to correctly pursue reimbursement, follow the roadmap the IRS lays out for you in IRS Regulation Section 1.62-2(c):
- As an employee submit expense reports to your corporation that include the expenses of your home office.
- Under the S-corp’s accountable plan, your business will reimburse you for the home office, claiming 100% of the home-office deduction as an office space.
- You will receive the reimbursement as a non-taxable reimbursed employee business expense.
To qualify a home office as a principal point of work, conduct most of your income-earning activities from inside it. Use the office to perform admin work and functions (make phone calls, send emails, read images, etc.). You will also need to audit-proof your reimbursement by properly documenting the expense and show exclusive, regular, and business use of your home office.
Tax Return Prep Tips
On the S-corp tax return, report the total reimbursement of the home office in the other deductions category as a line item labeled “office space”. Then, on your personal return, reduce your itemized deductions by the dollar amounts you received from the S-corp related to the office mortgage interest and property taxes.
Lastly, in the permanent file that you use for your personal taxes, be sure to track the depreciation that the corporation gives you for your home office. When you sell your home, you have to “recapture” depreciation and reduces your basis in your home. It’s always a good idea to keep records of this information, just in case.
In summary, the expense-report method I have described here is the only right and reliable method for achieving the full deduction for your home office.
#6 Rent Your Home to Your S-corp
You’re probably scratching your head right now going: what a minute? Didn’t you just tell me to sell the home? I did, but if you are not going to convert your home to a rental I am going to cover another way you can slash your S-corp taxes as it relates to renting your home.
As an S-corp owner, you can rent your entire home to the S-corp for up to 14-days per year and you don’t have to report the income. The S-corp will then deduct the full amount of the rent, which means you will accrue the income completely free of income tax. What could be better?
There are just a few things to be aware of if you are going to consider this path: don’t have the S-corp rent your home to entertain parties or customers. The entertainment facility rule disallows deductions for entertainment in any capacity. So, do not rent your home to your corporation for any entertainment use except for employee events and staff retreats. You can also rent your home to your corporation for business and board meetings.
If you are going to validate the rental, be sure to pay fair rental value and document the ordinary and necessary business activity to avoid flagging any IRS suspicion. It’s also wise to take pictures with date stamps as proof the event took place.
#7 Use of an Accountable Plan to Reimburse Travel Expenses
Let’s look at how an accountable plan can help you deduct more than just your home office: If you pay for a business expense out of pocket instead of through your business, your corporation can reimburse you under the accountable-plan rules. Within these rules, as the owner, you must incur these expenses in the performance of your duties for the corporation, and substantiate the expenses to the corporation in accordance with conditions set forth by the IRS. If you meet these payable requirements, or incur these expenses, the reimbursement becomes excluded from your gross income, not reported as wages on your Form W-2, and exempt from withholding and payment of employment taxes such as FICA. Do not claim these expenses personally on your Form 1040.
Below are some expenses that have special rules you should be aware of.
TIP: You can track your expenses via an Excel spreadsheet, online bookkeeping platforms such as QuickBooks Online, or apps such as Expensify. Contact me at [email protected] for an Excel spreadsheet with common expenses and expenses geared towards healthcare professionals.
If you are an S-corp owner that incurs business-related travel expenses, you must submit an expense report to achieve reimbursement by the S-corp. Travel expenses include airfare, car rental, baggage fees, lodging, meals, incidentals, etc. I recommend submitting an expense report with receipts on a monthly basis via your accountable plan. It is important to note that you cannot use the per-diem allowance method for reimbursement of lodging and must use actual travel expenses if you are more than a 10% owner (you can still use the standard meal allowances and incidental rates).
#8 Use of an Accountable Plan to Reimburse Cell Phone Expenses
The S-corp can reimburse the employee for the full cost of the phone and monthly services, deducting the amount on the business tax return. This makes the reimbursement tax-free income to the employee. Be sure to save the monthly cell phone bills and submit them with your expense reports on a monthly basis.
#9 Section 179 and Bonus Depreciation for Vehicles
Expanding on the vehicle deductions, a qualifying “heavy” vehicle (above 6,000 pounds) used for at least 50% business purposes can produce a Section 179 first-year depreciation deduction. With Section 179, you can expense up to $510,000 of qualifying new or used equipment placed in service. Heavy SUVs with GVWRs between 6,001 and 14,000 pounds are subject to a $25,000 limit on Section 179 expensing. If you are subject to the $25,000 limitation, any heavy new vehicles can also qualify for a 50% first-year bonus depreciation for the remaining depreciation base.
For example, if you buy a $45,000 heavy SUV, you can expense $25,000 under Section 179 and take $10,000 of 50% bonus depreciation on the remaining $20,000 of cost, and $2,000 of “normal” annual depreciation on the remaining $10,000 (20% x ($45k-$25K-$10k) in the same year. Total depreciation is $37,000 in the first year! A non-”heavy” vehicle used for at least 50% business use and classified as a passenger auto is subject to luxury auto depreciation limits. In contrast, using the example above, your depreciation write off in year one is only about $11,000.
It’s important to be aware that the Section 179 deduction is unable to exceed that year’s aggregate net business taxable income from all sources calculated before the section 179 write-off. Additionally, if your home office qualifies as a principal place of business, then all business trip to and from your place of work, such as a hospital, and even the office supply store, post office, etc, can rack up business miles and be reimbursed either via the standard business mileage deduction or actual expenses. This extra mileage will easily help you clear the “over 50% business use hurdle. Also, keep track of those trips between hospitals too if you work at more than one.
If you use your vehicle for personal and business mileage, you need to keep track of both by keeping a mileage log using a notebook or popular mileage apps such as MileIQ. In order to claim these deductions, you must keep all receipts and include these reimbursements in your W2 unless you have an Accountable plan set up.
#10 Contributing to Retirement
As most of you are aware, contributing to your pre-tax retirement accounts provides considerable tax savings. As an employee participating in any tax-deferred retirement plan (such as a 401(k), SEP, SIMPLE, or pension plan), your retirement contributions are deducted from each paycheck before taxes are taken out. Since contributions are taken out on a pre-tax basis, it lowers your taxable income, resulting in fewer taxes paid overall.
In my experience, for S-corps, it is best to set-up a solo 401(k) if you have no other employees but yourself, your spouse, and/or children. You can contribute up to $56K (2019) a year and also participate in a Backdoor Roth contribution ($6K in 2019) without being subject to pro-rata rules. However, if you want to contribute more than the $56K limitation for a solo 401(k), you’ll want to consider a Defined Benefit Pension Plan. These plans allow you to contribute up to six figures to your retirement plan along with the Backdoor Roth. Of course, each type of plan has their pros/cons and there is no one size fits all.
It’s recommended that you consult an advisor on this issue, especially if you have employees other than spouse and children.
Lower Your S-Corp Taxes
Now is the best time to start thinking about ways to reduce your tax burden as 2019 comes to an end. With a little patience and adequate documentation, it’s entirely possible to lower your S-corp tax burden for 2019. Remember, it’s important to be proactive throughout the year and to start implementing any strategies well before December 31st to take full advantage of their benefits.
I would love to hear about your takeaways, questions, or comments below!