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Slash family taxes on S corporation income

by on
in Small Business Tax,Small Business Tax Deduction Strategies

As an S corporation owner, you can avoid the double taxation that plagues income earned by a regular C corporation. Instead of being taxed twice—once on the corporation level and once personally—income flows through to the S corporation shareholders. So, it's only taxed once at your personal level.

For that reason, it makes sense to keep your salary as low as possible to minimize payroll taxes. But don't stop there.

Strategy: Transfer shares of the S corporation stock to your children. By doing that, some income is taxed to your children in their low tax brackets instead of your higher bracket.

If you follow the tax-law guidelines, you won't owe any tax on the transfers.

Example: Share the wealth

Say you're an S corporation employee-shareholder. The only other shareholder is your spouse, who doesn't work for the company. Your two children are in their late teens.

This year, your S corporation expects to distribute $300,000 to salary and bonuses. Instead of taking the entire $300,000, you pocket $100,000 in compensation. (You can reduce your payment as long as it's a reasonable amount for the services performed.)

The remaining $200,000 becomes corporate earnings, taxable on your joint return. Since you've converted earned income to unearned income, you don't have to pay the 2.9 percent Medicare tax—both the employer and the employee's share—on that amount. Result: You save $5,800 (2.9 percent of $200,000) right off the bat.

But you can do even better by shifting stock shares to your children. If your spouse joins in the gifts, you can give each child up to $22,000 worth of stock a year without any gift-tax consequences. And you might be able to transfer even more shares than you think.

Reason: Due to factors such as lack of control and illiquidity, closely held company shares typically have a lower value to outsiders than the current shareholders.

Suppose you own 2 million shares valued at $2 million, so each share appears to be worth $1. If you want to give a child a $22,000 gift this year, you might transfer 22,000 shares to him or her.

Hold it right there. Those 22,000 shares are undoubtedly worth a lot less than $22,000. Hire an independent appraiser to provide a realistic valuation. If the appraiser determines a value of 80 cents per share, you can actually give the child 27,500 shares a year without any gift-tax problems.

Remember that the company is showing a $200,000 profit. If you divest yourself of, say, 20 percent of the company over time through lifetime gifts to your two children, they will receive $40,000 a year from the S corporation (20 percent of $200,000).

Say that their marginal tax rate is 15 percent, as opposed to your usual 33 percent tax rate. That means your family saves $7,200 in income tax (18 percent difference times $40,000) each and every year. And that's in addition to the payroll tax savings!

 

You and your spouse still control 80 percent of the company, so you'll still call the shots.

Use strategy with older kids

In general, this tax strategy works only if your children are age 14 or older. That way, you don't have to deal with the "kiddie tax" on unearned income. For 2005, unearned income received by a child under 14 is taxed at the parents' highest marginal tax rate once it exceeds $1,600.

Consider using a trust. As an alternative, you can transfer the shares of S corp stock to a trust instead of directly to your children. Then name the children as the trust beneficiaries. Because you'll face some tax-law restrictions on S corporation transfers, work with an experienced tax pro.

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