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.
For the S corporation owner
As discussed, S corporation owners have to pay tax on the company’s earnings even if they don’t distribute the earnings to themselves. For this reason, traditional tax savings solutions, such as deferred compensation, won’t work for S corp owners. It makes no sense for them to defer taxes on their own wages and then pay income taxes on those same dollars as S corporation earnings.
An attractive pre-tax solution for an S corporation owner is a qualified plan. The contribution is deductible but not currently taxed to the owner. However, because they are for employees in general, the plans impose limits on both who must be covered and for how much.
Further, these are tax-deferred plans, not tax-free plans. The trade-off for a current tax deferral is paying tax on the accumulated amount (at ordinary income tax rates) during retirement. In essence, a qualified plan is a box the owner can fill up with deductions. Once the box is full, it’s time to think outside the box to see what other benefits are available. The S owner bonus plan may be such a benefit. (See chart.)
Like the executive bonus plan proposed above for executives, an S owner bonus plan can be a tax-effective retirement and death benefit strategy. With this plan, the business pays for a personally owned contract or policy.
Typically, the vehicle would be a permanent life insurance policy, funded at a high premium level. This would provide both death and retirement benefits on a tax-efficient basis. The premium on the policy is either taxed as compensation (W-2) or as an S corporation dividend (K-1).
The advantage of characterizing the premium as a dividend is that it is not subject to employment taxes such as Medicare. Keep in mind, however, that if there are multiple owners, the premium must be part of the allocable share of dividends to all the owners.
Either way, the S corp owner pays income tax on the premium. Assuming the policy is not a modified endowment contract, the cash values will grow tax-deferred and can be paid out tax-free. If the owner dies, the death benefits are income tax-free. If the owner retires, he or she can take tax-free withdrawals up to basis and then switch to loans against the cash value.
Consider the advantages of this plan to the S corporation owner.
o The plan offers income tax diversification. With a qualified plan, contributions are tax-deferred but taxable in full in the future. With the S owner bonus plan, using a permanent life insurance policy, the premium is taxed currently but avoids tax on growth in the future. It’s like paying tax on the seed but not on the harvest.
o The plan can be self-completing if life insurance is the chosen funding vehicle. Depending on the policy used, the premium may be waived in the event of disability. If the S corp owner retires, cash values may be available for retirement income. And, of course, when the owner dies, a death benefit would be paid.
o The S owner bonus plus plan involves distributed profit. The policy is an individually owned asset, unencumbered by the business.