An S-corporation offers significant tax savings compared to a C corporation. C corporations profits are taxed twice, once at the corporate level and again when profits are distributed to shareholders, whereas S-corporations pass through profits or losses to shareholders who report them on their individual tax forms, avoiding double taxation. In summary, S-corporation offers a tax-efficient structure as it eliminates the corporate level taxation, thus providing a way for shareholders to save on taxes.
Ways to pay yourself as an S-corp ?
S-corporation shareholders who are involved in the day-to-day operations have dual roles as shareholders and employees, while those who don’t participate in daily activities are considered only shareholders. The role played by the shareholder in the company impacts how they can pay themselves and the limits that apply under the S-corp structure. In summary, the level of involvement in the day-to-day operations of the S-corporation determines the pay structure and limits of the shareholders.
If you are an employee of the company, it is necessary to be compensated appropriately in order to pay employment taxes to the IRS. This compensation must be in the form of a wage, separate from any other forms of compensation that may be received as a shareholder. The IRS requires that S-corporation employees receive reasonable compensation, which is comparable to what other businesses in the same industry pay for comparable labor and expertise. This means that the compensation should be in line with the industry standards and not so low as to avoid paying required taxes.
It is important to note that the IRS views an attempt to minimize federal income tax liability by paying oneself a minimal salary and receiving the majority of revenue as distributions as an attempt to evade taxes. If the IRS finds that a shareholder’s salary does not qualify as reasonable compensation, the S-corporation may be fined for failing to withhold and deposit employment taxes, as well as forced to pay back taxes on what was not reported. Therefore, it is important to ensure that the compensation is reasonable and in line with industry standards to avoid any penalties from the IRS.
If an S-corporation has excess funds to cover future expenses, shareholders can also receive compensation in the form of dividends. These are distributions of profits to shareholders which are often made in the form of cash or stock. Shareholders who are not actively involved in the company’s operations and do not provide services to the S-corp can receive distributions instead of a salary. Unlike salary, distributions are not subject to employment taxes, but they are considered as part of the shareholder’s personal income for tax purposes. These distributions are tax-free until they surpass the shareholder’s stock basis, after which they become taxable. The stock basis represents the initial investment made by the shareholder in the business, which can be affected by business losses or income.
Salary and distributions
If you’re an owner and shareholder-employee, you have the option of receiving distributions in addition to your salary when the business is performing well. However, it is important to ensure that your salary meets the reasonable compensation standard set by the IRS, as failure to do so may result in reclassification of other compensation as taxable income. It is recommended to consult with a tax professional to understand the requirements of reasonable compensation before making this choice.