An S corporation operates a "pass-through" entity, meaning all corporate income and deduction items pass through to shareholders, who then report those amounts on their personal returns. Result: You owe personal income tax on your share of S corp profits.
So if you run your business as an S corporation, consider giving away some shares to low-bracket relatives, including your children, who'll owe less income tax. Share giveaways also can reduce payroll and estate taxes. Here's the full story:
Pour income into different buckets
Say you and your spouse are the only shareholders in XYZ Co., an S corporation. You are an employee, but your spouse isn't. In 2004, XYZ shows net income of $400,000, paid to you as salary and bonus.
Instead, you could pay yourself $120,000 salary as long as you can demonstrate that's comparable to other top executives' earnings at similar companies. The remaining $280,000 balance ($400,000 minus $120,000) is taxable to you and your spouse as corporate earnings on your joint tax return.
By shifting the $280,000 from earned to unearned income, you would save $8,120 in Medicare tax, assessed at 2.9 percent for employer and employee.
You can accomplish even better results by shifting shares to your children. You and your spouse can jointly transfer up to $22,000 worth of shares each year to each child, without incurring any gift tax. Using discounts for illiquidity and lack of control, you can make relatively large gifts.
Case study: XYZ Co.
Say your S corporation, XYZ Co., shows 2.2 million shares outstanding, valued at $2.2 million. If you want to transfer $22,000 worth of shares to your daughter, you might say that each share is worth
$1 and transfer 22,000 shares.
But 22,000 shares (1 percent of the outstanding shares) really aren't worth $22,000 (1 percent of the company). No outsider would pay that much, considering the lack of control over the company's activities.
So you can hire an appraiser who might say that 33,000 shares would be worth $22,000 to an outsider. If so, you and your spouse can give your daughter 33,000 shares this year.
With that strategy, you can give your daughter and your son a total of 660,000 shares in 10 years. At that point, your children will own 30 percent of the company.
In that case, if XYZ shows a $280,000 corporate profit, 30 percent of it (or $84,000) will be allocated as your children's share of the taxable income. So that amount of income will be taxed at their lower rates. If your kids are in a 25 percent tax bracket, rather than your 35 percent rate, that's an income tax saving of $8,400.
Including state taxes may mean even greater income tax savings.
Maximize strategy: 3 tips
1. Give shares to kids over age 14. The greatest payoff comes after your kids reach age 14. Reason: S corp earnings are considered unearned income. And, children under 14 can earn only $1,600 of unearned income in 2004. Larger amounts are taxed at the parents' rate.
2. Shift shares to trusts. If you don't want your kids to own shares outright, you can shift the shares into trusts, naming your children as trust beneficiaries. Restrictions exist on which types of trusts can be S corporation shareholders.
3. Realize estate-tax benefits. Trans-ferring S corporation shares to your kids will earn estate-tax advantages, too. In the earlier example, you removed 30 percent of your corporation's value from your taxable estate and your spouse's estate without incurring any gift tax. The process continues until you give away 49 percent of the shares for estate-tax purposes, yet you'll still retain control.
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