S corporations represent the majority of U.S. companies filing corporate income tax returns. Owners of these companies need effective tax planning strategies because they pay tax on all of their corporate earnings, even if those earnings have not yet been distributed.
For example, assume an S corporation owner in the 35% tax bracket has corporate earnings of $200,000 but only pays himself a $100,000 salary. His tax bill is $70,000 ($200K X .35), even though he leaves $100,000 of the earnings in the business. From a personal cash flow perspective, the owner has $100,000 to pay a $70,000 tax; he feels like he is in the 70% tax bracket.
Because of the immediate effect of corporate earnings on their personal taxes, S corporation owners are attracted to tax-efficient concepts. Owner and executive benefits are an example. Consider the following tax-efficient strategies that are available to S corp owners.
For the Executive
A common executive benefit for C corporations is a deferred compensation plan. However, both the owner and executives of an S corporation may be hesitant to install such a plan.
For the owner, deferring a tax deduction may be a concern; for executives, the company’s ability to fulfill the promise to pay in the future is also a concern. An executive bonus plan addresses both of these issues.
For the owner, contributions to the plan are immediately tax deductible. And because executives own the policy or contract, they needn’t worry about the company defaulting in the future.
The costs of the executive bonus plan can be equal to or even less than that of a deferred compensation plan. For example, assume an S corporation owner has five executives who wish to defer $100,000 into a deferred comp plan. To pay this benefit in the future, the owner will set aside $100,000. This set aside, however, is not currently deductible, costing the S corp owner $35,000 in current cash flow, plus any administrative fees associated with the deferred compensation plan.
Assume, instead, that an executive bonus plan is used. Under this plan, the executives agree to put their portion of the $100,000 in individually owned contracts or policies. The owner will “gross up” the income tax the executives have to pay on the $100,000, including the taxes, so that the executives have a zero net cost.
Assuming all the executives are in the 35% tax bracket, the before-tax cost to the owner for the gross-up is $53,846. Since the gross-up is an immediate tax deduction, the after-tax cost to the owner is $35,000–the same as the cost for the deferred compensation plan. Consider the other tangible benefits of an executive bonus plan:
o Little or no administrative costs to maintain the plan;
o As a fringe benefit for the executive, a cash value life insurance policy that covers the contingencies of both dying too soon and living too long; and
o The business does not have to book an ongoing liability; the premium is simply paid out as wages.