S-Corporations are a popular business structure because they offer some key tax advantages. But how do S corporation taxes work, and what are the benefits? In this post, we’ll answer those questions and more. So whether you’re already an S Corporation owner or are thinking of forming one, read on for everything you need to know.
Potential Benefits of an S Corp Election
There are a few reasons that an S corp business structure is appealing to business owners.
First, making an S corporation election may reduce their taxes. S corporations are pass-through entities, which means that the income and losses of the company are passed through to the shareholders and are taxed on their individual tax returns. This has an advantage over C corporations because it eliminates double taxation on the company’s income—C corps pay federal income tax on both corporate income and dividends paid to shareholders.
S corporations can also have an advantage over limited liability companies (LLCs) because S corp shareholders only pay self-employment taxes on their salary. Any company profits over and above their salary are taxable income but not subject to self-employment taxes (the self-employed person’s version of FICA).
While electing S corp status doesn’t always result in tax savings, it’s worth considering if the S corp generates enough profit to make the change in tax structure (and filing a separate S corp tax return) worth it.
How S Corporations Pay Federal Income Taxes
S corporations file Form 1120S, an information return that reports the company’s income, deductions, and credits for the year. The return is due by March 15 of the following year. No tax is due with the return.
Instead, S Corporation shareholders receive a Schedule K-1. The shareholders use that schedule to report their share of profits on Schedule E, which gets filed with their personal tax returns.
Are S Corp Distributions Taxable?
As an S corporation owner, you are considered both an owner and an employee. This means your compensation from the company consists of two parts: salary and distributions.
Let’s look at each of those components in more detail.
As an S Corporation owner who also works in the business, you’re required to pay yourself a reasonable compensation. This compensation is typically paid as a salary, and the company must withhold payroll taxes. If you’re the owner of an S-Corporation and are not currently processing payroll for yourself, please speak with your accountant. You can read more about S-Corporations and payroll here.
One of the key advantages of choosing S corporation status over a limited liability company is it limits self-employment taxes to the shareholder’s salary rather than owing self-employment tax on 100% of their share of profits. This can save a business owner a significant amount under the right circumstances.
The key word here, however, is “reasonable.” The Internal Revenue Service (IRS) generally expects you to pay yourself a salary comparable to what other organizations in your industry pay someone with similar experience for similar work.
If you don’t pay yourself a reasonable salary, the IRS can determine that you set your compensation low to avoid payroll taxes and recharacterize distributions as payroll. If that happens, you could be required to pay back payroll taxes and penalties.
The other component of S Corporation shareholder compensation is distributions. These are earnings payments to shareholders, which might come in the form of cash or stock.
S Corporation shareholders pay income taxes—but not payroll taxes—on their share of business income. This happens regardless of whether they leave the profits in the business or distribute them.
So any distributions you receive from the company are generally tax-free because you’ve already paid taxes on your share of the company profits. The key is to ensure those distributions don’t exceed your stock basis.
Your stock basis is your initial investment in the business, plus any increases from business profits or decreases due to business losses. If you take out more in distributions than you’ve invested in the company, you’ll pay taxes on the excess. This is known as distributions in excess of basis.
S Corp Taxes: An Example
Let’s look at an example of how S Corporation shareholders pay taxes on salaries and distributions.
Say Hapibloom Florist is an S Corporation with $100,000 in net income. The total profit of the S Corporation before any owner wages was $220,000, and the sole owner, Lea Bloom, paid herself a reasonable compensation of $120,000, bringing business income down to $100,000.
First, Lea pays income and employment taxes on her $120,000 salary. Assuming she’s in the 24% tax bracket, she’d pay roughly $19,528 in federal income taxes. She’ll also pay self-employment tax of $9,180 on that income.
Lea also pays income taxes on the $100,000 of taxable income generated by the S Corporation, so she’ll pay another $14,768 in tax on the business income (before any other deductions or tax credits she might be eligible to claim).
Let’s say Lea takes a $10,000 distribution the following year. That distribution isn’t taxable because she pays taxes on the S-Corporation income when she earns it, not when it’s distributed. S Corporations can be a great way to reduce your tax liability and keep more of your hard-earned money due to their ability to shield profits from self-employment tax. Please reach out if you’re interested in learning more about whether S Corporation status can benefit you or figuring out a reasonable compensation.