At our firm, we specialize in providing comprehensive tax planning services specifically tailored to the needs of S Corp owners in California. Let’s delve into this strategy and explore several approaches to optimize your tax situation.

The Classic Year-End Paycheck Strategy

One straightforward and effective tax planning strategy is to issue yourself a significant paycheck in December and call it a "bonus". This method aims to cover all remaining federal and state tax liability for the year with the funds from this paycheck. But how do you determine the precise amount needed? The CPA would need to conduct a thorough tax projection at the individual level and create a mock tax return for the upcoming tax filing that would give a projected tax liability. This process includes reviewing all sources of income—such as wages, dividends, and other income streams—and considering specific tax deductions for the year. Once the CPA figures out your individual tax liability, they can process a payroll for this amount. Instead of receiving the paycheck as cash, the funds will be sent directly to federal and state tax agencies.

Implementing this year-end paycheck strategy offers several key benefits:

1. Avoid Underpayment Penalties: By ensuring your year-end paycheck covers your tax liability, you minimize your underpayment penalties. Both the IRS and California’s Franchise Tax Board (FTB) impose penalties for underestimating your tax payments and they calculate those penalties based on the time the estimated penalties were paid. But when you make payments though your wages, the IRS and FTB do not have an exact date of payment and that reduces estimated payments penalty. This strategy helps you stay compliant while reducing estimated tax penalties.
2. Keep the IRS Happy: A bonus amount increases your total wages on your W-2. This means your "reasonable compensation" as an S Corp owner will be higher and you will pay more self employment taxes on your income. And this will make the IRS happy. A substantial year-end paycheck helps demonstrate that you are meeting reasonable compensation requirements, potentially reducing the likelihood of an audit.
3. Manage Cash Wisely: Issuing a large paycheck at the end of the year allows you to retain more funds within the business throughout the year. This can be particularly beneficial for managing operating expenses, investing in business growth, or maintaining a stronger cash reserve.

If you prefer a more proactive approach, you can implement this strategy periodically throughout the year ( for example, four times a year) or opt for quarterly estimated payments via check or bank payments.

Beyond the Basics: Additional Tax Planning Strategies

While the paycheck strategy is a solid starting point, it's just one aspect of a comprehensive tax planning approach. Here are additional strategies that can come in handy:

1. Accountable Plans for Reimbursements: Implementing an accountable plan allows you to reimburse yourself for business expenses such as mileage, home office costs, or meals without these reimbursements being treated as taxable income. This strategy enables you to withdraw cash from your business while classifying it as an expense rather than a distribution. This can be particularly advantageous in avoiding reasonable compensation audits.
2. Retirement Contributions: Maximizing contributions to retirement plans, such as a SEP IRA or Solo 401(k), can significantly reduce your taxable income. These contributions are deductible, helping you build long-term wealth while also lowering your current tax bill. SEP IRA contributions depend on the amount of your W-2, and SEP IRA accounts are usually very small with S Corps, since most S Corp owners want to show small reasonable compensation in their attempts to avoid self employment taxes. However, a Solo 401(k) allows you to stash away a large amount of money, since with Solo 401K you calculate your contributions based on your W-2 and also company's net profit. The more profit your S Corp made, the more you will be allowed to stash into your Solo 401K plan.
3. Income Splitting: For S Corp owners with family members involved in the business, income splitting can be a powerful tool. By shifting income to family members in lower tax brackets, you can effectively reduce the overall tax burden on your family unit.
4. California Pass-Through Entity Tax (PTET) Deduction: High-net-worth business owners in California can benefit from the Pass-Through Entity Tax (PTET) deduction. This allows you to deduct your personal California taxes on your federal return. To implement this strategy effectively, it is essential to consult with your CPA and also to make a payment twice a year—in June and at the end of December.
5. Acceleration of expenses: This is a classic strategy employed by many of us. Made too much money? Buy a piece of equipment before December 31st, prepay your rent, or increase your charitable contributions, harvest your capital losses and so on. Or, if possible, wait to bill your clients until the next year.

Conclusion

Effective tax planning for California S Corporation owners goes beyond just issuing a year-end paycheck. By combining this strategy with other tax-saving techniques such as accountable plans, retirement contributions, income splitting, and leveraging the PTET deduction, you can maximize your savings and ensure compliance with both federal and state tax regulations.