According to IRS data, over five million small businesses operate as S corporations, primarily to benefit from lower payroll taxes by paying themselves modest salaries. While this is a common strategy, many S corporation owners are unaware of the numerous advanced tax planning opportunities available. These strategies can significantly reduce their tax burden and maximize their business’s financial performance.    

To ensure we’re all on the same page, let’s start with a straightforward tax-saving strategy for S corporations.

Consider a business owner earning $100,000. If the business is a sole proprietorship or partnership, the owner pays Social Security and Medicare taxes—around 14%—on most of the $100,000, resulting in about $14,000 in payroll taxes.

However, if the business is structured as an S corporation, tax law allows the owner to divide the $100,000 into wages and a shareholder distribution. For example, by splitting it into $50,000 in wages and $50,000 in distribution, the payroll tax is reduced by half, saving over $7,000 annually.

Many S corporation shareholders stop at this point, but several other advanced tax planning strategies are available for S corporations.    

Strategy #1: Boost Section 199A Deduction with Higher Wages

Many S corporation owners focus on minimizing payroll taxes by keeping W-2 wages low. However, if your business generates Section 199A qualified business income and you have a high income, you need sufficient wages to maximize your Section 199A deduction.

This deduction prevents you from paying income taxes on the last 20% of your taxable income. For incomes above certain thresholds—around $200,000 for single filers and $400,000 for married filers in 2024—the deduction is capped at 50% of the W-2 wages paid by the business.

While you must pay yourself a reasonable salary, increasing your wages might be necessary if you miss out on the full Section 199A deduction. You should allocate 2/7ths of your profits as wages and 5/7ths as shareholder distributions.

Example: An S corporation owner earns $7,000,000 in profit and pays herself $500,000 in W-2 wages. This limits her Section 199A deduction to $250,000. If she increases her wages to $2,000,000, her deduction could rise to $1,000,000, potentially saving $280,000 in taxes.

Strategy #2: Separate Specified Service Trade or Business (SSTB) to Qualify for Section 199A

Another strategy involves maximizing the Section 199A deduction, particularly for high-income S corporations that may lose this deduction because part of their business is classified as a Specified Service Trade or Business (SSTB). SSTBs include many traditional professions, performers, athletes, and celebrities.

If you run multiple trades or businesses, some of which are SSTBs and some are not, combining them in a single S corporation disqualifies the entire entity from the Section 199A deduction. The solution? Split the SSTB and non-SSTB operations into separate S corporations to requalify for the deduction.

Example: A physician earns $400,000 from practicing medicine (an SSTB) and another $400,000 from providing continuing medical education services. If these activities are combined in one S corporation, he likely loses the 199A deduction on the full $800,000, as the SSTB taints the entire income. However, by splitting the activities into two separate businesses, potentially using two S corporations, he could secure an $80,000 deduction on the non-SSTB income, saving around $30,000 annually

A strategic tax option for S corporation shareholders residing in states with income taxes is electing to pay a pass-through entity tax. This approach allows the S corporation to directly pay the state income taxes on profits that would normally be owed by individual shareholders. The benefit is significant: while personal state tax payments over $10,000 are generally not deductible on federal returns due to SALT limitations, taxes paid by the S corporation as a pass-through entity tax are fully deductible at the business level. 

For example, if you owe $30,000 in state taxes on S corporation profits, having the business pay this as a pass-through entity tax could result in a full $30,000 federal deduction. At a 24% federal tax rate, this strategy could save approximately $7,200 in federal taxes, making it a powerful tool for tax efficiency. 

Strategy #4: Utilize Tax-free Fringe Benefits

Maximizing tax-free fringe benefits is a savvy strategy for S corporation shareholders. By incorporating these benefits into your compensation package, you can effectively increase your total remuneration without incurring additional payroll taxes. For instance, consider an S corporation generating $100,000 in profit. If the owner-employee wishes to draw a $50,000 salary, this might be deemed unreasonably low. However, by adding $30,000 in health insurance benefits, which count as wages but are exempt from both income and payroll taxes, the total compensation package rises to $80,000. 

This higher figure is more likely to be considered reasonable compensation, satisfying IRS requirements while optimizing the owner’s tax position. This approach allows S corporation shareholders to balance their personal financial needs with tax efficiency and compliance considerations.

Strategy #5: Set up a Generous Pension for Shareholder-employees  

S corporation shareholders can leverage generous pension plans as an effective tax planning strategy, simultaneously reducing tax liability and building wealth outside their business equity. This approach serves two purposes:

1. Attracting and retaining talent by offering competitive benefits to employees.
2. Optimizing the shareholder-employee’s tax position and retirement savings.

Key pension options include:

1. Simplified Employee Pension (SEP): Allows contributions up to 25% of W-2 wages. For example, on a $50,000 base salary with $30,000 in health benefits, a $20,000 SEP contribution could be made, potentially saving on both income and payroll taxes.
2. 401(k) plans: These can combine 25% employer contributions with employee elective deferrals ($23,000 in 2024, or $30,000 for those 50 and older).
3. Defined benefit plans: In special cases, these can allow for even larger contributions, potentially reaching low to mid six-figures in some situations.

These pension contributions not only reduce tax liability but also contribute to meeting the “reasonable compensation” requirement for S corporation shareholders. By structuring compensation to include substantial pension contributions, shareholders can optimize their overall tax strategy while building significant retirement savings.    

Strategy #6: Own Partnership Interests Through an S Corporation

S corporations can be strategically used to own partnership interests, offering a powerful tax planning opportunity. This structure, often misunderstood, allows shareholders to combine the benefits of both entity types:

1. S corporations can own partnership interests, though partnerships cannot own S corporation shares.
2. By holding partnership interests through an S corporation, owners can apply S corporation tax benefits to partnership income.
3. This approach is particularly valuable for partnerships generating self-employment income, as it can help reduce self-employment taxes.
4. The tiered structure (S corporation owning partnership interests) allows shareholders to benefit from:
   • S corporation tax advantages discussed earlier
   • Partnership flexibility in allocating income and deductions
5. This combination often provides a “best of both worlds” scenario, maximizing tax efficiency and operational flexibility.

Shareholders should consult with a tax advisor to properly structure this arrangement and ensure compliance with all relevant regulations. This strategy can be especially beneficial for those with multiple business interests or those seeking to optimize their overall tax position across various income sources.

Strategy #7 Leverage Self-Rental Rules for Substantial Real Estate Deductions

The self-rental rules offer a powerful tax strategy for S corporation owners, allowing them to potentially use real estate losses to offset business income. Here’s how it works:

1. Normally, passive activity loss rules (Section 469) limit the ability to use real estate losses against active business income.
2. However, by electing to group a self-rental property with the active trade or business using that property, S corporation owners can bypass these limitations.

Key points:

• Ownership percentages of the rental property and S corporation must match.
• The grouping election must be made when acquiring the property.
• When done correctly, depreciation deductions from the real estate can shelter the business’s income.

Additionally:

• Accelerated depreciation methods can be used to frontload deductions.
• In some cases, 10-30% of the property’s purchase price might be immediately deductible.

This strategy requires careful planning and execution, but it can significantly reduce overall tax liability for S corporation owners who also invest in real estate used by their business. As always, consult with a qualified tax professional to ensure proper implementation and compliance.

Conclusion

If you’re interested in exploring these tax strategies but don’t currently have a CPA or tax advisor, Thomas Huckabee CPA is available to assist you. We offer free initial consultations to discuss your specific situation and how these strategies might benefit your business. To set up a consultation or learn more about how we can help optimize your S corporation’s tax position, please contact us. Our team is ready to provide expert guidance tailored to your unique needs.