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Managing Your S Corporation through the Downturn

By Stephen Nelson

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Published: 12Jun2009
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Subchapter S corporations make sense for many small businesses. With an S corporation, the corporation doesn't have to pay income taxes on its profits. And shareholders often minimize their payroll tax bills.

But the S corporation tax classification--a classification available to both regular corporations and limited liability companies--creates some problems when the economy sinks into a recession. If you own or operate an S corporation, therefore, you'll need to take the following precautions in order to continue reaping a healthy harvest of tax savings.

Precaution #1: Don't Overcompensate Shareholder-employees

A first, obvious tip regarding S corporations in years when profits are down: You maybe don't want to pay shareholder-employees so much you create a loss inside the S corporation.

Now understand--you do need to pay shareholder-employees reasonable compensation. Employees logically still get paid even when their corporate employer falls on hard times. But what you don't want to do is put money into the corporation just so you can take it back out again as a salary. This round-trip transaction doesn't cost you income taxes. But the transaction does cost you payroll taxes. In other words, if you put $100,000 into your S corporation so you can pay yourself $100,000 of salary, just moving the money around this way creates roughly a $15,000 payroll tax bill. Ouch.

Precaution #2: Protect the Self-employed Health Insurance and Pension Deductions

Tough times may mean you want to or need to cut shareholder-employee compensation. But before you get too aggressive, remember that some of your business and personal deductions depend on you enjoying earned income.

To receive the self-employed health insurance deduction, for example, you do need employee wages at least equal to the health insurance deduction. And to get retirement savings deductions, you also need employee wages.

Accordingly, even in a tough economy where your S corp doesn't make much money or even loses money, you may still want to pay yourself modest wages--even if paying those wages means contributing money to the corporation.

Precaution #3: Take Care with the Sec. 179 Depreciation Write-off

Small businesses commonly don't depreciate their fixed assets: equipment, furniture, machinery and so forth. In 2009, for example, the typical small business can expense (immediately write off) up to $250,000 of fixed assets instead of having to depreciate this stuff over three, five or seven years.

This immediate write-off is called a Section 179 election because Section 179 of the Internal Revenue Code authorizes and spells out the rules for taking the write-off. Section 179 elections provide a wonderful tax deduction, but there's a gotcha. You can only take a Section 179 election if the business entity shows a profit. You can't in other words use the Section 179 election to create or increase a business loss.

In profitable years, this limitation doesn't matter. In a recession, however, the limitation does matter if your business suffers a loss. And note: Even if your business shows a tax loss, you might personally still want to save income taxes because of earned income or investment income.

Precaution #4: Monitor Shareholder Basis in S Corp Stock (and Debt)

One other quick warning: If an S corporation loses money, shareholders can often use that loss as a deduction on their personal tax returns (assuming the shareholder actively participates in the business).

However, in order to use an S corporation loss as a deduction on the shareholder's personal return, the shareholder needs basis in their S corporation stock and (if applicable) in S corporation debt.

As a practical matter, the basis limitation means that only losses funded through shareholder's personally invested (or reinvested) capital or direct-from-that-shareholder loans get counted as tax deductions. If the money that shows up as being "lost" comes from some other shareholder or some outside lender (like the bank) the loss deduction may be delayed into the future.

The Wall Street Journal once called Seattle accountant Stephen L. Nelson the Louis L'Amour of computer books. A one-time tax professor at Golden Gate University, Nelson is also the author of a series of downloadable do-it-yourself S corporation ebooks including titles about setting up a Florida S corporation and setting up a New York S corporation.

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