How to Use Your S-Corp Shares as a Tax Saving Tool

It is estimated that nearly 5 million businesses in the US are legally identified as an S-corporation

(S-corp.) This is a business that has filed with the IRS to be taxed under Chapter S of the Internal Revenue Code.

There are several advantages as to why this choice would be selected:

• Pass-Through Taxation: Instead of the business paying a corporate income tax on profits, all income, losses, deductions and credits “pass-through” to the business owner on their personal tax returns. The value this provides is that the business owner pays taxes on their income based on their individual tax rate. This is likely to be lower than a corporate tax rate. This structure avoids the risk of double taxation (such as can be found with a C-corporation) where the corporation is taxed first and then the proceeds to shareholders are taxed again.

• Limited Liability: It provides asset protection to the owner, with their personal assets (home, car, bank accounts) protected against business debts and legal claims.

• Self-Employment Taxes: The business owner can split their income into two categories: a “reasonable salary”  and a distribution. A reasonable salary is defined as to what a person with similar responsibilities and size of company would earn if they were not the business owner. The reasonable salary is subject to payroll taxes( Social Security, Medicare), while the distribution portion of their income is not. The value of this is the ability to enjoy a lesser overall tax burden.

There a several requirements that an S-corp must abide:

• Domestic corporation: The business must be based in the US.

• Shareholder limits: There can only be a maximum of 100 shareholders.

• Citizen/residency requirements: Shareholders must be US citizens or residents. Certain trusts and estates can also exist as shareholders. Partnerships, non-resident aliens, and corporations are not allowed to own shares.

• Class stock: Only one class of stock can exist.

In many instances, the need to liquidate S-corp shares becomes a top-of-mind concern when a business owner is planning a business exit and looking to sell their business.

In an effort to lessen the capital gains tax bite that they are likely to experience, the business owner can rely on charitable giving as a powerful tool for smart tax planning. With any business sale, a team of advisors is needed to have the process occur smoothly.

S-Corp Shares and Charitable Giving

Although there a variety of ways to donate S-corp shares to a charitable cause, this article will focus on how S-corps shares can be used to open and utilize a donor advised fund.

A donor advised fund (DAF) is a charitable investment account which can only be used for charitable purposes. Money can go in but never leave unless it is directed toward charitable causes. This type of account provides a variety of benefits, including tax reduction, flexibility, privacy, and (unlike a private foundation) no requirements concerning minimum annual payouts to charity.

The general guidelines to do this successfully are as follows:

• By donating a portion of their S-corp stock before the sale closes, the business owner can avoid capital gains tax on the fair market value of the donated shares.

• The donation must occur before the sale is finalized. Timing is critical. Doing this process after the sale closes eliminates the capital gains tax saving advantage.

• At the instance of the sale, the DAF is already a shareholder, and the sale value of the donated shares goes directly into the DAF account.

• Those charitable dollars are directed by the former business owner, allowing them to fund charitable causes important to him and on a schedule of his choosing.

Conclusion

The savvy use of S-corp shares to lessen the capital gains tax burden is innovative but requires following select steps and proper timing. Generosity Nexus has the depth of experience and technical insight to manage this level of charitable giving & tax planning complexity. We have nearly 15 years of executing instances of an S-corp transition numerous times.

Don’t hesitate to schedule an appointment to learn more about how we can help you.