S Corporation Tax Planning: Key Strategies for Reducing Taxes and Protecting Shareholders

S corporations offer several strategic advantages for tax planning, making them an attractive choice for business owners looking to save on taxes. Let's explore key areas where S corporations can provide tax benefits, protect shareholders, and enhance estate planning.

S Corporation Tax Reduction Opportunities: Save on Taxes with These Strategies

1. Gifting Shares to Family Members

One effective strategy for reducing taxes is by gifting shares of your S corporation to family members in lower tax brackets. For example, if you, as the shareholder, are in the 37% tax bracket and gift shares to a family member in the 20% bracket (such as an elder parent), you can lower your family's overall tax burden by 17% on the income from those shares.

However, keep in mind that this strategy may trigger a gift tax return, so it's important to consult with a tax advisor to ensure compliance with IRS rules.

2. Reducing Payroll Taxes

An S corporation provides a valuable tax-saving opportunity by allowing shareholders to reduce their salary (subject to payroll taxes) and increase their pass-through income. The income passed through to shareholders isn’t subject to payroll taxes, meaning the shareholder only pays payroll taxes on their salary.

This strategy can lower the overall tax burden for shareholder-employees, but it must be approached carefully. The IRS scrutinizes compensation levels to ensure they are "reasonable." If the salary is deemed unreasonably low, the IRS may reclassify some of the pass-through income as salary, subject to payroll taxes. For more information on how to determine reasonable compensation, check out our guide on reasonable compensation for S Corp owners.

Additionally, reducing salary can also affect pension plan contributions and social security benefits, so this strategy should be considered with long-term planning in mind. You can read up on this topic here.

3. Cross-Purchase Agreements: A Strategy for Shareholder Transition

In an S corporation, shareholders can establish a cross-purchase agreement, where one shareholder commits to buying the shares of another shareholder when they retire. This arrangement benefits the surviving shareholders by increasing their stock basis by the amount paid for the shares.

Conversely, if the corporation itself buys back the shares, the surviving shareholder’s stock basis remains unchanged, which could lead to a larger tax burden when the business is sold.

Shareholder Protection Opportunities in S Corporations

1. Preserving S Corporation Status

An S corporation’s status can be at risk if shares are sold to ineligible entities, such as nonresident aliens. To safeguard the corporation’s status, ensure all shareholders sign a stock repurchase agreement. This agreement should outline that shares may only be transferred to eligible shareholders, thus maintaining S corporation status.

2. Preserving the Original Shareholder Group

If you want to ensure that the original shareholder group remains intact, consider implementing a shareholder agreement that gives current shareholders the right of first refusal. This agreement allows them to purchase shares before they are sold to outsiders, preserving the ownership structure and maintaining control within the founding group.

3. Ensuring Fair Share Pricing

Disputes over share pricing can lead to legal challenges. To avoid this, include a clear pricing formula in the shareholders' agreement. This will standardize the process for determining the share price, providing fairness and transparency in any share transfer or buyback.

4. Retaining Parental Control in S Corporations

For parents who own an S corporation and wish to gift shares to their children while maintaining control of the business, a shareholder agreement can help. The agreement can specify that children must vote for their parents to retain certain corporate roles, allowing the parents to keep authority and control even after transferring ownership.

5. Minimum Distribution Requirement

An S corporation’s pass-through taxation means shareholders must pay taxes on the corporation’s income, even if no distributions are made. To help shareholders manage their tax liabilities, a shareholders' agreement can require that a specific percentage of the corporation’s earnings be distributed each year.

However, it's important to include a clarification clause to ensure these distributions don’t compromise the corporation’s financial stability or lead to insolvency.

Estate Planning Opportunities with S Corporations

1. Minority and Lack of Control Discount

Parents who own an S corporation can transfer a minority interest to their children, reducing the fair market value of those shares through a "minority and lack of control" discount. While the law does not specify a fixed discount percentage, courts have often accepted a 30% reduction. This strategy allows parents to shift assets out of their estate while transferring income to children, who are typically in a lower tax bracket.

2. Gift Tax Exclusion

By gifting shares to others, shareholders can reduce their ownership in an S corporation up to the annual gift tax exclusion limit. By keeping gifts within the allowable threshold, recipients do not incur any taxes on the received shares. Additionally, these shares may be eligible for a discount due to the lack of control, allowing you to gift more shares.

As with any gifting strategy, the recipient inherits the donor’s original basis in the shares, so it’s essential to understand the implications on capital gains taxes when shares are eventually sold.

If you're a small business owner looking for expert assistance with S Corp tax planning, we’re here to help. Our team has successfully helped hundreds of business owners save on taxes and maximize their financial strategies. Explore our services here and start saving today!