How S Corporations Can Save on Federal Employment Taxes

If you own an unincorporated small business, you may be getting fed up with high self-employment (SE) tax bills. One way to lower your SE tax liability is to convert your business to an S corporation.

SE Tax Basics

Sole proprietorship income as well as partnership income that flows through to partners (except certain limited partners) is subject to SE tax. These rules also apply to single-member limited liability companies (LLCs) that are treated as sole proprietorships for federal tax purposes and multimember LLCs that are treated as partnerships for federal tax purposes.

For 2017, the maximum federal SE tax rate of 15.3% hits the first $127,200 of net SE income. That rate includes 12.4% for the Social Security tax and 2.9% for the Medicare tax.

The rate drops after SE income hits $127,200 because the Social Security tax component goes away above the Social Security tax ceiling of $127,200 for 2017 (up from $118,500 for 2016). But the Medicare tax continues to accrue at a 2.9% rate, and then it increases to 3.8% at higher income levels because of the 0.9% additional Medicare tax. (This 0.9% tax applies to the extent that wages and SE income exceed $200,000 for singles and heads of households, $250,000 for married couples filing jointly, and $125,000 for married couples filing separately. The tax is part of the Affordable Care Act, so it likely will disappear if the ACA is repealed or replaced.)

We’ll refer to the Social Security and Medicare taxes collectively as federal employment taxes.

Example 1

Suppose your sole proprietorship is expected to generate net SE income of $200,000 in 2017. Your SE tax bill will be $21,573 [($127,200 x 15.3%) + ($72,800 x 2.9%)]. That’s a sizable amount — and it’s likely to get bigger every year due to inflation adjustments to the Social Security tax ceiling and the growth of your business.

SE Tax Reduction Strategy

To lower your SE tax bill in 2017 and beyond, consider converting your unincorporated small business into an S corporation and then paying yourself (and any other shareholder-employees) a modest salary. Distribute most (or all) of the remaining corporate cash flow to the shareholder-employee(s) as federal-employment-tax-free distributions. Here’s why this SE tax-saving strategy works.

For compensation paid to an S corporation employee in 2017, including an employee who also is a shareholder, the FICA tax rate is 7.65% on the first $127,200. This includes 6.2% for the Social Security tax and 1.45% for the Medicare tax. Above $127,200, the rate drops to 1.45% because the Social Security tax component goes away. But the 1.45% Medicare tax component continues indefinitely. At higher wage levels, S corporation employees must also pay the additional 0.9% Medicare tax. FICA tax is paid by the employee through withholding from employee paychecks.

The employer then pays in matching amounts of Social Security tax and Medicare tax (other than the additional 0.9% tax) directly to the U.S. Treasury. So the combined FICA and employer rate for the Social Security tax is 12.4%, and the combined rate for the Medicare tax is 2.9%, rising to 3.8% at higher income levels. These are the same as the SE tax rates. That’s the bad news.

The good news is that S corporation taxable income passed through to a shareholder-employee and S corporation cash distributions paid to a shareholder-employee aren’t subject to federal employment taxes. Only wages paid to shareholder-employees are subject to federal employment taxes.

This favorable federal employment tax treatment places S corporations in a potentially more favorable position than businesses that are conducted as sole proprietorships, partnerships or LLCs (if treated as sole proprietorships or partnerships for federal tax purposes).

Example 2

Assume the same facts as the previous example, except this time you operate your business as an S corporation that generates net income of $200,000 before paying your salary of $60,000. (Assume you could find somebody to do the same work for about that amount.) Only the $60,000 salary amount is subject to federal employment taxes, which amount to $9,180 ($60,000 x 15.3%). That’s significantly lower than you’d pay as a sole proprietor ($21,573).

The Caveats

This tax-saving strategy isn’t right for every business. Here’s some food for thought as you consider changing your business structure:

1. Operating as an S corporation and paying yourself a modest salary will save SE tax as long as your salary can be proven to be reasonable, albeit on the low side of reasonable. Otherwise you run the risk of the IRS auditing your business and imposing back employment taxes, interest and penalties.

However, you can help minimize the risk that the IRS will successfully challenge your stated salary amounts if you gather objective market evidence to demonstrate that outsiders could be hired to perform the same work for salaries equal to what you’re paying shareholder-employee(s).

2. A potentially unfavorable side effect of paying modest salaries to S corporation shareholder-employee(s) is that it can reduce your ability to make deductible contributions to tax-favored retirement accounts. If the S corporation maintains a Simplified Employee Pension (SEP) or traditional profit-sharing plan, the maximum annual deductible contribution for each shareholder-employee is limited to 25% of his or her salary.

So, the lower the salary, the lower the maximum contribution. However, if the S corporation sets up a 401(k) plan, paying modest salaries won’t preclude generous contributions.

3. Operating as an S corporation will require some extra administrative hassle. For example, you must file a separate federal return (and possibly a state return, too).

In addition, transactions between S corporations and shareholders must be scrutinized for potential tax consequences, including any transfers of assets from an existing sole proprietorship or partnership to the new S corporation. State-law corporation requirements, such as conducting board of directors meetings and keeping minutes, must be respected.

In most cases, these drawbacks are far less burdensome than the potential SE tax savings. Your tax advisor can help you minimize the downsides and work through the details.

Weighing the Upsides and Downsides

Converting an existing unincorporated business into an S corporation to reduce federal employment taxes can be a smart tax move under the right circumstances. That said, consult a WFY tax advisor at info@cpa-wfy.com to ensure that all the other tax and legal implications are considered before making the switch.

Mechanics of Converting to S Corporation Status

To convert an existing sole proprietorship or partnership to an S corporation, a corporation must be formed under applicable state law and business assets must be contributed to the new corporation. Then an S election must be made for the new corporation by a separate form with the IRS by no later than March 15, 2017, if you want the business to be treated as an S corporation for calendar year 2017.

If you currently operate your business as a domestic limited liability company (LLC), it generally isn’t necessary to go through the legal step of incorporation in order to convert the LLC into an entity that will be treated as an S corporation for federal tax purposes. That’s because the IRS allows a single-member LLC or multimember LLC that otherwise meets the S corporation qualification rules to simply elect S corporation status by filing a form with the IRS. However, if you want your LLC to be treated as an S corporation for calendar year 2017, you also must complete this paperwork by no later than March 15, 2017.

 

© Copyright 2017. All rights reserved.

Brought to you by: Wright Ford Young & Co.

Factoring Uncertainty into the Value of Your Business

Businesses currently face numerous uncertainties in the marketplace. As President Trump and Republican congressional leaders work toward fulfilling their campaign promises, tax laws could substantially change, the estate tax could be repealed, and various laws and regulations (including the Dodd-Frank and Affordable Care Acts) could be repealed or revised. Interest rates and inflation could both rise. Economic relationships with other countries could also change. Some of these changes could be good for your business, while others could have negative effects on the value of your business.

History Lesson

Business valuation professionals are no strangers to dealing with market uncertainties — and neither are business owners and investors. The approach to valuing a business interest doesn’t change because of the uncertainties surrounding the current political environment.

Under the market and income approaches, the value of a business continues to be a function of expected economic returns and market, industry and specific company risk. These fundamentals didn’t change during other events that caused uncertainty earlier in the 21st century, such as the terrorist attacks on September 11, 2001, or the Great Recession that lasted from December 2007 to June 2009.

Key Considerations

Here are some considerations when valuing a business in today’s volatile political climate.

Public market returns. The inputs that valuators use to determine discount rates and pricing multiples are typically based, in part, on data from the public stock and bond markets. So far, public markets have reacted to the election results in a positive manner. In general, the proposed changes to taxes and business regulations are likely to lower expenses and increase cash flow for many businesses.

Company-specific risks. A factor that has changed substantially is the risk associated with specific companies and industries — and valuators face challenges as they attempt to measure these risks. For example, proposed regulatory changes might increase the value of companies that operate in the energy sector or the manufacturing sector. On the flipside, they might adversely affect the value of companies that operate in the government contracting or health care sectors.

Known (or knowable) information. Many private business valuations are prepared with a year-end effective date, because it corresponds to the cut-off date for their annual financial statements. Valuation experts can only use information known or knowable at the date of the valuation. But what did we know as of December 31, 2016?

Valuation experts constantly monitor market conditions. Realistically, at the end of 2016 and even today, there are many unknowns. The specific details of tax reforms and other regulatory proposals haven’t been fully put into effect or made into law. Since we can only speculate on what will happen in the future, business valuators must focus on the likelihood that the subject company will achieve its expected future income. The risk that a company won’t meet its financial forecasts is factored into its discount rate.

Contact a Valuation Pro

Experienced appraisers understand the importance of reacting to events that cause added uncertainty with an objective, measured response, rather than a knee-jerk response. In today’s marketplace, they understand that politicians have many divergent plans that may (or may not) be approved or take effect.

In the meantime, business owners and investors should stay calm and carry on. A valuation professional can help you stay atop the latest tax and regulatory changes and understand how they could impact your company’s expected return and risk profile in the future. For additional information consult a WFY tax advisor at info@cpa-wfy.com.

Public Markets Respond to the Election Results

Following the election and through the end of 2016 — the effective date for many private business valuations — the Standard & Poor’s 500 Composite Stock Price Index, a leading indicator of large stocks, has responded positively.

Specifically, the S&P 500 index increased from $2,139.56 on November 8, 2016, to $2,163.26 on November 9, 2016, an increase of 1.1% from the closing price on Election Day. As of December 31, 2016, the S&P 500 index had risen to $2,238.83, an increase of 4.6% compared to the closing price on Election Day.

It’s important to note that changes in the S&P 500 index aren’t exclusively tied to the election results — and sometimes the market misjudges the impact of major events. However, the performance of the S&P 500 does provide a general indication of investors’ expectations about expected economic returns and systematic risk that can assist in valuing businesses in today’s uncertain marketplace. When valuing small private firms, however, current events in the public markets can be less of a factor than estimating long-term economic income probabilities.

© Copyright 2017. All rights reserved.

Brought to you by: Wright Ford Young & Co.

Leverage Benefits to Recruit and Retain Talent

It’s a lot more efficient to retain good employees than to find and hire new ones. The Society for Human Resource Management (SHRM) recently asked its members how they are adapting their employee benefit programs to avoid losing quality workers. Two-thirds of respondents in the study represent employers with fewer than 500 employees.

SHRM’s “Strategic Benefits” study set the stage by asking employers how many are having a tough time retaining highly skilled employees. Fully 37% reported that this is a problem for them — up from 27% only four years ago. That challenge was more acute among self-described “high-tech” companies.

More than one-third of respondents reported difficulty retaining employees at all levels within the organization, up from 25% in 2012.

Nearly one in five surveyed employers changed their benefits plans within the last year. And among high-tech companies, one in four did so.

How many companies have changed these benefits in the past year?

Employee Segment
Benefit category All High performing Highly skilled
Health care benefits 61% 44% 44%
Flexible working arrangements 37% 31% 35%
Retirement savings plans 35% 25% 27%
Leave benefits 34% 27% 28%
Career development 34% 36% 34%
Wellness 26% 23% 23%
Family-friendly benefits 14% 10% 10%

Source: SHRM 2016 Strategic Benefits Survey

What did employers change? As the table above indicates, among the employers that made changes, health care benefits were altered by the majority. Some employers differentiated benefit plan changes for the various employee segments.

Employee Segment Targeting

As the table shows, 44% of the employers made changes particular to high-performing and highly skilled workers. Also, career development plans were more prevalent for high-performing employees among employers that changed those benefits.

That finding was consistent with a widely held view that professional and career development benefits are becoming more critical to employee retention. Slightly smaller majorities of respondents also believe that flexible working benefits, health care benefits, retirement savings plans and wellness programs will become more important.

Family-friendly benefits are seen to be dropping in importance, with only 28% believing they will grow in value (vs. 55% 2013).

When asked which benefits will be more critical to helping employers retain high-performing employees, respondents overwhelmingly identified career development (70%), and slightly smaller majorities named health care benefits, retirement plans and flexible working arrangements. Similar benefit priorities were ascribed to high-performing employees.

Millennial Priorities

Career development and flexible working arrangements were also considered vital to the retention of millennial generation workers, with 83% and 80% of survey respondents, respectively, identifying those benefits.

The SHRM survey asked employers the same set of questions with respect to recruiting new workers. Their responses generally fell into the same pattern.

One noteworthy finding, however, is that employers see the primary bread-and-butter benefits — health and retirement plans — gaining importance in the recruitment of employees at all levels of the organization, but career development and flexible working arrangements as becoming a larger draw for millennial and highly skilled employees.

The survey did not get “into the weeds” on the kinds of changes survey respondents made to their plans. The general trend with health plan changes in recent years has been a shift to high-deductible health plans (HDHPs) paired with health savings accounts. However, that’s been a mixed bag for employees.

According to the Kaiser Family Foundation, in 2016 the average employee contribution to HDHP premiums was $943 for single coverage and $4,289 for family coverage. Those numbers are 16% and 19%, respectively, lower than the average of all health plan types. However, employees who incur higher than average number of medical claims typically wind up paying more under HDHPs than HMO or PPO plans by virtue of the higher deductible.

Relative Competitiveness

Employers who consider health benefits as a vital tool for retaining and recruiting employees need to only make their plans less costly to employees than their competitors do, even while overall costs to employees are on an upward path.

Expanding flexible working arrangements, in contrast, doesn’t necessarily entail an increase in employer costs, so long as there’s no productivity drop among employees who use these programs. In general, with proper supervision and the appropriate kind of job (that is, one in which employees don’t need a lot of facetime with colleagues), the productivity issue goes away.

Similarly, career development benefits, which are so cherished by millennials (as are flexible working arrangements) don’t need to add significant costs to your employee “total compensation” budget.

Making an effort to sketch out a probable career path for talented employees may not cost anything. And while additional training programs do increase costs, if the net result is better trained and more loyal employees, that expense becomes a long-term investment in the future of your organization.

© Copyright 2017. All rights reserved.

Brought to you by: Wright Ford Young & Co.

Can a Creditor Go After Non-Probate Assets?

When someone dies, one of the first questions that close relatives usually have is whether they are personally responsible to pay the credit card bills of the decedent. They may even start getting telephone calls from creditors asking them to pay outstanding balances.

Close relatives may also want to know: Who is responsible for paying the mortgage of the decedent? If they are entitled to inherit money, can they take their share regardless of the creditors? This article will discuss estate debt issues and the more specific issue of whether a creditor has a right to attach non-probate assets of the decedent. First, let’s briefly review the process.

Probate assets are assets that are in the name of the decedent only. So if the decedent had a bank account in his or her own name and no beneficiaries are named on a pay-on-death form, the money in the account would “pass through” probate. If the decedent held the bank account jointly with another individual (such as a spouse), in the majority of cases money in the bank account would pass directly to the joint account holder outside of probate.

Likewise, if a house was in the name of the decedent only, it would pass through probate. If the decedent owned the house with someone, as joint tenants with rights of survivorship or with a spouse as tenancy by the entirety, the house would pass directly to the joint owner and outside of probate. This is also true when decedents have beneficiary designations in pay-on-death bank accounts or transfer-on-death brokerage accounts.

So, what rights do creditors have to reach the assets of the decedent to pay off the debts? A creditor can file a claim against an estate for payment of the debt. The executor or personal representative must pay the creditors from probate assets before a final distribution of money is made to heirs. If the personal representative distributes money to heirs when debt is outstanding, a creditor can file a claim or lawsuit against:

  • The heir(s) for the return of the money; or
  • The estate executor or personal representative if the individual refuses to file a petition to have the heir turn over the money to the estate.

What if there is no money in the estate to pay creditors? A creditor may look to non-probate assets to pay debts. This may happen if there is an indication that the assets of the decedent were large and if there was a transfer of money in order to avoid the debt.

For example, let’s say an individual owes $100,000 to a credit card company and puts assets in a joint bank account prior to death to avoid payment of the debt. The credit card company can file a claim for the money. Creditors could demand that the beneficiaries who inherited assets use them to pay some or all of the debt.

Retirement Accounts, Insurance, Trusts

When it comes to creditors, not all assets in an estate are handled in the same way. Retirement account assets and insurance proceeds with designated beneficiaries are treated differently than other assets and provide more protection from creditors. Money in a revocable trust is subject to creditor claims while assets in an irrevocable trust — when structured properly — are generally exempt from creditor claims.

Knowing the rules for limiting creditor exposure is important for those structuring their estates and for heirs of decedents with outstanding debts. Your attorney can help you with these issues.

For additional information contact a WFY tax advisor at info@cpa-wfy.com.

© Copyright 2017. All rights reserved. Brought to you by: Wright Ford Young & Co.

IRS updates FAQs on Certain ACA Provisions

The Trump Administration and the Republican majority in Congress plan to repeal and replace the Affordable Care Act (ACA) in the coming months. In the meantime, however, employers must continue to comply with the existing rules for 2016, including the information reporting requirements and shared responsibility provisions.

The IRS previously issued three sets of FAQs that provide guidance on employer responsibilities under the Affordable Care Act (ACA). This guidance was recently updated to include significant clarifications and help employers ensure that they’re in compliance with the rules. Here, we highlight the extensive updates that were issued in December 2016 and that you may find useful in fulfilling your information-reporting obligations for 2016, if you’re subject to the requirements.

Background

The employer shared responsibility provisions of the ACA require an applicable large employer (ALE) to pay a penalty if it doesn’t offer minimum essential health coverage (or doesn’t offer coverage that is affordable and provides minimum value) to its full-time employees and at least one full-time employee purchases coverage through a health insurance marketplace and receives a premium tax credit. Full-time employees are generally those who average at least 30 hours of service per week during a given month.

An ALE for a calendar year is an employer that employed an average of at least 50 full-time employees or the equivalent on business days during the preceding calendar year. To determine the number of full-time equivalent employees (FTEs), the overall hours worked by part-time employees during a month are added up, and the total is divided by 120 hours (equal to four weeks multiplied by 30 hours per week) and added to the number of full-time employees. However, the actual penalty is applicable solely to the health coverage status of full-time employees, not FTEs.

FAQs on Information Reporting

There are various reporting requirements associated with the employer shared responsibility provisions that apply to both coverage providers and employers. In general, every health insurance issuer, sponsor of a self-insured health plan, government agency that administers government-sponsored health insurance programs and other entity that provides “minimum essential coverage” must file annual returns reporting information for each individual for whom such coverage is provided. They also must furnish a written statement to each individual listed on the return showing the information that must be reported to IRS for that individual.

The information reported on Form 1094-C, Transmittal of Employer-Provided Health Insurance Offer and Coverage Information Returns, and Form 1095-C, Employer-Provided Health Insurance Offer and Coverage, is used to determine whether an employer may be liable for a penalty under the employer shared responsibility provisions of the ACA, as well as the amount of any penalty. Form 1095-C is also used by the IRS and the employee in determining the eligibility of the employee (and his or her family members) for the premium tax credit.

The FAQs provide additional information about completing these forms for the 2016 calendar year (for filing in 2017). Here’s what’s been revised under the updated guidance:

Question 9. Do ALE members that are combined to form a single employer (an “aggregated ALE group”) file one authoritative transmittal reporting summary information for all ALE members in the aggregated ALE group?

The revisions clarify that an aggregated ALE group may not file one authoritative transmittal reporting summary information for all members in the group. Rather, the reporting requirements apply separately to each member.

Question 26. Should an ALE member report coverage under a Health Reimbursement Arrangement (HRA) for an individual who’s enrolled in both the HRA and the employer’s other self-insured major medical group health plan?

Under the updated guidance, enrollment in an HRA must generally be reported in the same manner as enrollment in other minimum essential coverage, unless an exception applies. One such exception is that if an individual is covered by two or more plans that provide minimum essential coverage and that are provided by the same reporting entity, reporting is required for only one of them for that month.

Question 27. Should an ALE member report coverage under an HRA for an individual who’s eligible for the HRA because the individual is enrolled in the employer’s insured group health plan?

The revised guidance states that if an individual is eligible for an HRA because the individual is enrolled in an employer’s insured group health plan for which reporting is required, reporting generally isn’t required for the HRA.

However, an ALE member must report HRA coverage for an employee who’s enrolled in the HRA but not enrolled in another group health plan of the employer.

FAQs on Offers of Health Insurance Coverage

Certain employers are required to report to the IRS information about whether they offered health coverage to their employees and, if so, information about the coverage offered. This information also must be provided to employees. With respect to reporting offers of health insurance coverage, the FAQs provide that:

Question 23. For purposes of reporting, including reporting facilitated by a third party, may an ALE member file more than one Form 1094-C?

The revisions explain that an ALE member may file more than one Form 1094-C, provided that one (and only one) of those transmittals is an “authoritative transmittal” reporting aggregate employer-level data for the ALE member.

Question 24. May an ALE member satisfy its reporting requirements for an employee by filing and furnishing more than one Form 1095-C that together provide the necessary information?

Under the updated guidance, an ALE member may not satisfy its reporting requirements for an employee by filing and furnishing more than one Form 1095-C that together provide the necessary information. There must be only one Form 1095-C for each full-time employee for that full-time employee’s employment with the ALE member.

FAQs on the Shared Responsibility Rules

If you still have questions about whether you’re considered an ALE for 2016 and whether you’ve complied with the shared-responsibility requirements, you may find the revised FAQs regarding the employer shared responsibility provisions helpful:

Question 8. If an employer hires additional employees, including some part-time employees, how does it determine if the entity has become large enough to be an ALE?

The revisions clarify that if an employer hires additional employees, including some part-time employees, during the current calendar year, the employer must take those employees into account when determining if it’s an ALE for the next calendar year.

Question 9. Do the employer shared responsibility provisions apply only to large employers that are for-profit businesses or to other large employers as well?

The revisions clarify that all employers that are ALEs are subject to the employer shared responsibility provisions. This includes for-profit, government and nonprofit employers, regardless of whether the entity is a tax-exempt organization.

Question 20. Is a full-time equivalent employee different than a full-time employee?

According to the revised answer to this question, the number of an employer’s FTEs is relevant only for purposes of determining whether the employer is an ALE.

Question 24. How does an employer count a particular employee’s hours of service if that employee works for two employers that are treated as one employer under the employer shared responsibility provisions (for example, different subsidiaries under a parent corporation that together form an aggregated ALE group)?

The rules for combining employers that have a certain level of common, or related, ownership, apply for purposes of determining whether an employer employs at least 50 FTEs.

Question 28. What counts as an “offer of coverage” under the employer shared responsibility provisions?

The updated guidance stipulates that an ALE makes an “offer of coverage” to an employee if it provides the employee an effective opportunity to enroll in the coverage (or to decline coverage) at least once for each plan year. Coverage refers to minimum essential health coverage under an eligible employer-sponsored plan.

Question 34. For purposes of the employer shared responsibility provisions, in determining what counts as an offer of coverage to at least 95% of an employer’s full-time employees (and their dependents), does an employer have to take into account full-time employees (and their dependents) that are eligible for coverage through another source?

Under the revisions, the determination of what counts as an offer of coverage to at least 95% of an ALE’s full-time employees applies regardless of whether any full-time employees have coverage from another source, such as Medicare, Medicaid or a spouse’s employer.

Question 43. Who’s an employee’s dependent for purposes of the employer shared responsibility provisions?

The revisions explain that a dependent is an employee’s child, including a child who has been legally adopted, or legally placed for adoption with the employee, who has not reached age 26. A dependent doesn’t include:

  • A spouse, or
  • A stepchild, foster child or child who doesn’t reside in the United States (or a country contiguous to the United States) and who isn’t a U.S. citizen or national.

Question 44. If an ALE is made up of multiple employers (called ALE members), is each separate ALE member liable for its own employer shared responsibility payment, if any?

According to the updated answer, if an ALE is made up of multiple ALE members, each separate ALE member is liable for its own employer shared responsibility payment.

Still Got Questions?

The rules for providing health care benefits can be overwhelming to employers. These FAQs offer some guidance, but tax and financial professionals can help explain the shared responsibility provisions and the related reporting requirements using plain English. Contact your WFY tax advisor at info@cpa-wfy.com for additional guidance.

Also be aware that the deadlines for filing ACA information forms are fast approaching. The due date for filing 2016 Forms 1094-B, Transmittal of Health Coverage Information Returns; 1095-B, Health Coverage, 1094-C and 1095-C with the IRS are February 28, 2017, if not filing electronically, or March 31, 2017, if filing electronically. However, the IRS extended the information reporting deadlines until March 2, 2017, for furnishing 2016 Forms 1095-B and 1095-C to individuals.

In the meantime, stay tuned for changes to health care coverage requirements. Health care reform has been made a top priority during President Trump’s first 100 days in office and Congress has already begun to pass related legislation.

© Copyright 2017. All rights reserved.

Brought to you by: Wright Ford Young & Co.