The S Corporation and Tennessee Taxation

This blog post will not touch most of you, but, for those of you it does touch, it will be very important.  As a fee-only advisor, I work with many different types of business owners, and today’s post is meant for those who own S Corporations.

More and more small business owners are establishing their businesses as S Corporations.  This business structure has several benefits, but it also has some pitfalls that can lead to unexpected taxation.

As a pass-through entity, an S Corp passes along income (and losses) to the business owner.  Generally, an S Corp doesn’t pay tax at the entity level (the business) because it passes income through to the business owner where it’s taxed at the personal level.

There are two ways an S Corp business owner can pay himself: either as a shareholder distribution (considered a dividend) or through payroll as an employee.

One of the benefits of an S Corp is income that is passed through to the business owner in the form of a shareholder distribution (dividend) will avoid payroll taxes. For example, a business owner who pays himself a $50k payment (considered a dividend) from business profits can avoid payroll taxes on this payment, which may generate several thousand dollars in savings.  But, a dividend payment to the business owner may generate additional taxes for Tennessee Residents.

This dividend payment may factor into Franchise and Excise taxes, as well as, the TN Hall tax (income tax), which are levied at the rate of 6.5% and 6% respectively.  So, a simple business dividend payment could end up costing a business owner 12.5% in taxes….that’s $6250.00 on the $50k example.

Most often in this situation it may make more sense for the business owner to simply pay themselves through payroll as an employee.

While there are several nuances to S Corp taxation and this is by no means a total pros and cons comparison, it simply illustrates the complexities of an S Corp. It’s extremely important to proactively review S Corp taxation and how it impacts the business owner’s bottom line.  Sometimes what may seem like a benefit may actually turn into a liability.

About the author

Troy Von Haefen, CFP®
Troy Von Haefen, CFP®

3 Comments

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  • The Tennessee Franchise and Excise tax is 6.5% of net earnings (excise) and $.25 per $100 of net worth of the business (franchise). Tennessee doesn’t seem to understand that the franchise tax is regressive and it is one of the only few states in the south that still assess it in the way it does without any caps. It is a tax on business growth and capital. Nevertheless, to minimize your F&E tax as an S Corp in Tennessee you will do so through salary/earnings. The loan method is used for other purposes but in the case of an s-corp it will not minimize your F&E Tax as it is an asset on the books for your net worth calculations. It actually makes F&E tax higher to have net earnings and a commensurate loan on the book as an asset on the F&E. As for the federal tax you will pay the same amount either way with regard to income tax as it is pass thru with an s-corp. You will however trade the 12.5% Tennessee Tax for the 15.3% SS/Medicare but at least you get a more direct benefit for the trade off. Not to mention Social Security currently has a cap whereas the TN F&E does not. Moreover, to reduce the F&E increase your salary/earnings in Tennessee and keep few if any appreciating assets in your entity or assets that do not have offsetting liabilities to decrease net worth. It is sad that I recommend reducing your net worth as business, but unfortunately that is the Tennessee business tax structure. Perhaps they will repeal the F&E or cap it in the future, I believe the state just repealed the Hall Income Tax over the next several years so that will begin to help the S-Corp owner in Tennessee.

  • Re: Hall Income Tax on S-Corporation Distribuitons

    Someone told me that it’s best to reclass any distributions
    as loans
    to lower your Hall Tax bill.

    But then the owner would have to pay back the loans.

    And in order to payback the loans he would have to increase his pay.

    BUT, Increasing his pay would increase his federal taxes
    which are way more than 6%

    What am i missing?

    BTW, thank for your article

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