Contents
- Service professionals: SE-tax mitigation + reasonable comp enforcement
- Reasonable comp vs QBI: the optimization conflict
- Solo 401(k): salary as a retirement lever
- Fringe benefits: the 2% shareholder rule (health insurance trap)
- Real estate: 311(b) “asset trap”, debt trap, and estate planning limits
- Passive income “sting tax” (1375) for former C corps
- Tech startups: QSBS (1202), VC incompatibility, and SAFE/convertible risks
- Exit planning: 338(h)(10) as a buyer/seller bridge
- Operational mechanics: basis limits, suspended losses, accountable plans
- 2025 checklist: what to model and document
1) Service professionals: SE-tax mitigation + reasonable comp enforcement
For consultants and freelancers, the S corp value proposition is wage/distribution bifurcation: only W-2 wages are subject to payroll taxes, while distributions are generally exempt from FICA. The central compliance tension is the IRS “reasonable compensation” doctrine, which is enforced through case law recharacterizing low-salary distributions as wages. :contentReference[oaicite:2]{index=2}
Case-law principle (practical)
When gross receipts are primarily generated by the shareholder’s labor and reputation, the wage component must reflect that economic reality—making “tiny salary / huge distribution” structures fragile. :contentReference[oaicite:3]{index=3}
Defensible method
The report emphasizes a data-backed “cost of labor” approach: decompose the owner’s roles (delivery, sales, admin) and price each role using market wage data. :contentReference[oaicite:4]{index=4}
2) Reasonable comp vs QBI: the optimization conflict
Salary decisions are not only about payroll tax. At higher income levels, the Section 199A QBI deduction can be limited by W-2 wages. That creates a “sweet spot” problem: lower wages can increase payroll-tax savings but reduce QBI capacity; higher wages can preserve QBI but increase FICA costs. The report frames this as a modeling exercise—not a fixed ratio. :contentReference[oaicite:5]{index=5}
3) Solo 401(k): salary as a retirement lever
The report connects S corp comp strategy to retirement optimization: employer profit-sharing contributions are a clean percentage of W-2 wages, letting owners calibrate salary to reach targeted contribution limits. This can justify higher “reasonable” wages even when pure payroll-tax minimization would suggest otherwise. :contentReference[oaicite:6]{index=6}
4) Fringe benefits: the 2% shareholder health insurance reporting trap
A frequent audit/compliance failure is mishandling 2% shareholder fringe benefits. The report emphasizes the required mechanics: the corporation must pay or reimburse premiums under a plan, include the amount on the shareholder’s W-2 (income-taxable, but generally not FICA-taxable), and the shareholder claims the appropriate above-the-line deduction if eligible. Missing the W-2 step can wipe out the intended tax benefit. :contentReference[oaicite:7]{index=7}
5) Real estate: why S corps are often a “tax trap”
For buy-and-hold real estate, the report highlights two structural problems. First, distributing appreciated property triggers gain at the corporate level as if sold at fair market value (a “dry tax hit”). Second, S corps lack partnership-style inside-basis step-up mechanisms that are central to real estate estate-planning efficiency. These issues can make restructuring expensive or impossible without triggering tax. :contentReference[oaicite:8]{index=8}
The flipper exception
The report carves out an important exception: active flippers/wholesalers often benefit from S corp payroll-tax shielding because profits are ordinary income and the long-term “trapped asset” concerns are less relevant. It suggests a dual-entity approach: S corp for operations + LLC/partnership for rentals. :contentReference[oaicite:9]{index=9}
6) Passive income “sting tax” (1375) for former C corporations
For S corps with accumulated C-corp earnings and profits, the report details the Section 1375 “sting tax” risk when passive investment income exceeds thresholds. It also flags the potential for S status termination if the condition persists across consecutive years—making it a critical hazard for real-estate-heavy entities with C-corp history. :contentReference[oaicite:10]{index=10}
7) Tech startups: QSBS and VC realities
The report explains why S corps are structurally incompatible with many VC-backed models: (1) QSBS under Section 1202 is a C-corp stock benefit, and converting later can reset the 5-year clock; (2) S corps cannot have many investor entity types as shareholders; and (3) preferred economics can create a second class of stock and terminate the election. It also flags convertibles and SAFEs as “second class of stock” landmines depending on their terms and potential recharacterization. :contentReference[oaicite:11]{index=11}
8) Exit planning: 338(h)(10) as a buyer/seller bridge
In acquisitions, buyers often want asset treatment (basis step-up) while sellers want stock sale treatment (capital gains). The report summarizes how a 338(h)(10) election can treat a stock sale as an asset sale for tax, enabling negotiation (sometimes with price premiums) to reconcile these competing interests. :contentReference[oaicite:12]{index=12}
9) Operational mechanics: basis limits, suspended losses, and accountable plans
Across all archetypes, the report stresses “mechanics discipline.” Losses are deductible only to the extent of shareholder basis; guarantees do not create basis; excess losses are suspended and can be lost if the entity exits before basis is restored. Finally, accountable plans are positioned as a high-impact, low-drama tool to reimburse owners for business expenses (including home office) in a way that is deductible to the S corp and generally tax-free to the owner when properly substantiated. :contentReference[oaicite:13]{index=13}
2025 checklist: what to model and document
- • Reasonable comp file: role “hats,” market wage support, and a defensible narrative. :contentReference[oaicite:14]{index=14}
- • QBI vs FICA model: test wage levels at your taxable income band. :contentReference[oaicite:15]{index=15}
- • Solo 401(k) plan design: align W-2 with desired employer contributions. :contentReference[oaicite:16]{index=16}
- • 2% shareholder benefits: ensure correct W-2 reporting for health insurance. :contentReference[oaicite:17]{index=17}
- • Real estate governance: avoid trapping appreciating property inside the S corp; isolate flipping ops if needed. :contentReference[oaicite:18]{index=18}
- • C-corp history review: monitor E&P + passive income to avoid 1375/termination risk. :contentReference[oaicite:19]{index=19}
- • Startup financing plan: confirm shareholder eligibility, one-class-of-stock posture, and QSBS roadmap before money arrives. :contentReference[oaicite:20]{index=20}
- • Basis ledgers: stock vs debt basis, and a policy for capital injections/loans. :contentReference[oaicite:21]{index=21}
- • Accountable plan: written policy + substantiation workflow (receipts/logs). :contentReference[oaicite:22]{index=22}