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Do S Corps Pay Taxes

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C Corporations And S Corporations

How S Corp Taxes Work

Each corporation is formed under the laws of the state where it’s filed. Two kinds of for-profit corporations exist for tax purposes under federal law.

  • C corporations: These are the traditional corporations and must pay corporate income tax. C corps are taxed as separate entities from shareholders.
  • S corporations: These corporations get to enjoy the limited liability protection of a corporation while avoiding taxation at the corporate level. Both income and losses in an S corp pass through to shareholders.

The only difference between a C corp and an S corporation is the difference in how each is taxed. Otherwise, they’re identical entities under state law.

Distributions Dividends And Other Compensation As Wages

Courts have found shareholder-employees are subject to employment taxes even when shareholders take distributions, dividends or other forms of compensation instead of wages.

In 2001, in a Tax Court case against a Veterinary Clinic, the Tax Court ruled that an employer cannot avoid federal taxes by characterizing compensation paid to its sole director and shareholder as distributions of the corporations net income rather than wages. Veterinary Surgical Consultants, P.C. vs. Commissioner, 117 T.C. 141 .

The Sixth Circuit held that a shareholder-employee of a company used the company bank account for personal use. As such, the Court ruled the shareholder was an employee and owed employment tax. Joly v. Commissioner, T.C. Memo. 1998-361, affd by unpub. op., 211 F.3d 1269 .

In yet another similar case, the Tax Court held that an accountant was taking dividends and performing duties for the company. The Tax Court ruled the dividends were actually wages, subject to employment taxes. Joseph M. Grey Public Accountant, P.C. vs. Commissioner, 119 T.C. 121 .

Other decisions:

If the shareholder received or had the right to receive cash or property, then the S corporation must determine and report an appropriate and reasonable salary for that shareholder. See the S Corporation Compensation and Medical Insurance Issues page for more details on what is considered to be reasonable compensation.

S Corporation Compensation And Medical Insurance Issues

When computing compensation for employees and shareholders, S corporations may run into a variety of issues. The information below may help to clarify some of these concerns.

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Irs Requirements For An S Corp

To qualify for S corporation status, a business has to meet certain Internal Revenue Service requirements. It has to be incorporated domestically , have only one class of stock, and not have more than 100 shareholders. In addition, those shareholders must meet certain eligibility requirements, which means that they must be individuals, specific trusts and estates, or certain tax-exempt organizations . Partnerships, corporations, and nonresident aliens cannot qualify as eligible shareholders.

S corp shareholders report income, gains, and losses from the corporation on their individual tax returns, and they pay taxes at their ordinary income tax rates. Since the money comes to them free of corporate tax, they avoid double taxation on any income or earnings from the corporation.

Disadvantages Of An S

The Dual Tax Burden of S Corporations

Because an S-corp will mean more complicated tax withholdings, you can expect your accounting fees to increase, especially if you wouldnât otherwise have employees and payroll expenses. An S-corp may also require separate tax filings. Therefore, it may only be worth operating an LLC as an S-corp when your company reaches a certain income threshold, and the additional costs and fees make sense from an accounting perspective.

If youâre on the fence about whether or not it makes sense to structure an LLC as an S-corp, itâs a good idea to speak to an accountant about the specific additional costs and the income threshold that justify the tax benefits of an S-corp. If you are just getting started with your business and are still unsure about how much income your LLC will generate, you may want to consider holding off on setting it up as an S-corp.

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S Corporations And Employment Taxes

As passthrough entities, S corporations generally do not pay entity-level tax on their taxable income.3 Instead, taxable income and other attributes are allocated among the shareholders, who report the items and pay the corresponding tax on their personal income tax returns.4

This S corporation flowthrough income has long enjoyed an employment tax advantage over that of sole proprietorships, partnerships, and LLCs. The advantage finds its genesis in Rev. Rul. 59-221,5 which held that a shareholders undistributed share of S corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, a general partner, or many LLC members are subject to self-employment taxes.6

As the need to fund Social Security and Medicare payments has risen, the employment tax burden on employers, employees, and the self-employed has increased dramatically. In 2011, employers will pay 6.2% of the first $106,800 of an employees wages toward the Social Security tax, with employees paying an additional 4.2% through wage withholding. Employers and employees will split the 2.9% Medicare tax on all wages, without limitation.

Self-employed individuals will be responsible for the entire 10.4% Social Security taxagain limited to the first $106,800 of self-employment incomeand the 2.9% Medicare tax on all self-employment income.

Yes You Pay Tax On Distributions

This is a little confusing, because you dont withhold payroll taxes that 15.3% we mentioned, a.k.a. self-employment tax from your distributions. But you will, in fact, still owe federal income tax on that income.

And if the total income tax youll owe on self-employment income is $500 or more, you cant wait until April 15 to pay all of it at once. You as a taxpayer need to make estimated quarterly tax payments.

Worried about underestimating or forgetting to pay quarterly taxes? You can always boost the withholding from your employee salary to cover that obligation throughout the year.

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How Do S Corporation Taxes Work

Dont let the word corporation confuse you. S corporations dont pay corporate income tax. Instead, S corporations enjoy pass-through taxation in which the companys owners pay taxes on their portion of the companys earnings based on their individual tax rates.

To get S corporation tax treatment, register your business as a C corporation or limited liability company . From there, file IRS Form 2553 to elect S corporation taxation.

Not all C corporations and LLCs can take advantage of the S corporation tax status. Check out all the eligibility requirements in The Ascents guide to S corporations.

Does An S Corporation Shareholder Need To Pay Quarterly Taxes

How to Pay Estimated Taxes as an S Corporation

An S Corporation shareholder is generally required to make estimated tax payments, as taxes must be paid as you earn or receive income throughout the year, either through withholding or estimated tax payments. Estimated tax payments are used to pay not only income tax but also other taxes such as self-employment tax and alternative minimum tax.

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Paying Taxes On The Profit Share

When the shareholder reports the S corporation profit share on his or her tax return, the shareholder will owe federal and state income taxes on the profit share.

Just for the record, a shareholder can postpone dealing with this tax liability until tax return time. In this case, though, two bad things happen.

First, the shareholder finds him- or herself dealing with a last-minute tax payment. On a $25,000 profit share, for example, a shareholder with other income such as from a job might owe $8,000 or so in income taxes. That’s a lot of money for most people to come up with by April 15.

Second, if the taxpayer delays paying taxes on the profit share until April 15, the IRS and the equivalent state agency charges the taxpayer interest. Why? Because the federal and state government don’t want to wait until April 15 for their money. Rather, they want the shareholder to pay the taxes owed in even, quarterly chunks in the year in which the profit is earned.

Specifically, the government wants the shareholder to pay a quarter on April 15 and then another quarter on June 15, September 15, and on January 15 in the next year.

In the case where a shareholder owed $8,000 in taxes on his profit share, he or she should pay $2,000 quarterly deposits on April 15, June 15, September 15 and on January 15.

Note: Logically, it doesn’t make any sense for the second quarter’s payment to occur even before the second quarter ends on June 30. Accordingly, don’t try to figure this out.

How To Pay Yourself As An S

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Structuring your small business as an S corporation, or S-corp, can save money in federal taxes, but owners have to tread carefully when deciding how to pay themselves. Taking too low of a salary or skipping one altogether can lead to unpaid taxes and federal fines.

An S-corp offers business owners three basic options for paying themselves: by salary, distributions or both. The right choice depends largely on how you contribute to the company and the company’s finances.

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S Corporation Shareholders Are Required To Compute Both Stock And Debt Basis

The amount of a shareholder’s stock and debt basis in the S corporation is very important. Unlike a C corporation, each year a shareholder’s stock and/or debt basis of an S corporation increases or decreases based upon the S corporation’s operations. The S corporation will issue a shareholder a Schedule K-1.

It is important to understand that the K-1 reflects the S corporation’s items of income, loss and deduction that are allocated to the shareholder for the year. The K-1 shows the amount of non-dividend distribution the shareholder receives it does not state the taxable amount of a distribution. The taxable amount of a distribution is contingent on the shareholder’s stock basis. It is not the corporation’s responsibility to track a shareholder’s stock and debt basis but rather it is the shareholder’s responsibility.

If a shareholder receives a non-dividend distribution from an S corporation, the distribution is tax-free to the extent it does not exceed the shareholder’s stock basis. Debt basis is not considered when determining the taxability of a distribution.

Can You Pay Yourself On A 1099

Business Entities and Taxes

Since IRS Form 1099-MISC, Miscellaneous Income and Form 1099-NEC, Nonemployee Compensation are intended to report payments made to individuals who are not employees, they are generally not an option for S corporation owners, many of whom are also employees. These individuals may report their salary earnings via Form W-2 and any income received through shareholder distributions via Schedule K-1.

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How Do I File My Taxes As An S Corp

Form 1120S, U.S. Income Tax Return for an S Corporation is the tax form S corporations use to file their federal income tax return.

1120S is a five page form from the IRS, which looks like this:

Youâll need the following information on hand before filling out 1120S:

  • General information about your business, including your date of incorporation and the date you elected S corp status
  • A profit and loss statement and a balance sheet for your business
  • Information about any payments you made to independent contractors totaling at least $600 for the year

Page one of 1120S is divided into four parts:

  • The top third of the form containing fields A-F is where youâll input your contact information, dates of incorporation and S corp election, your assets, etc.

  • The Income section will ask you about all of your companyâs revenues for the year, which is information youâll get from your income statement.

  • The Deductions section is where youâll record all of your businessâ deductible expenses for the year, which youâll also get from your income statement .

  • The Tax and Payments section applies to corporations that began the year as a C corporation and filed for S corp status during the current tax year. Youâll use this section to list any estimated taxes you paid during the year, and calculate any taxes you owe or overpaid due to the switch.

  • There are also six schedules attached to 1120S, the first three of which are mandatory:

    Loss Or Deduction Pass

    If a shareholder is allocated an item of S corporation loss or deduction, the shareholder must first have adequate stock and/or debt basis to claim that loss and/or deduction item. In addition, it is important to remember that, even when the shareholder has adequate stock and/or debt basis to claim the S corporation loss or deduction item, the shareholder must also consider the at-risk and passive activity loss limitations and therefore may not be able to claim the loss and/or deduction item.

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    Irs S Corp Case Examples

    Not convinced you have to worry about a reasonable salary? Here are two real-life examples that demonstrate the importance of paying attention to this requirement:

    • An accountant in Arkansas was paying himself no salary and $83,000 in distributions. In an audit, the IRS used information from a large financial services recruiting firm to determine a reasonable salary for an Arkansas CPA to be between $45,000 and $49,000, and the accountant faced back-taxes and penalties.
    • A CPA in Iowa paid himself a $24,000 annual salary and received $220,000 in distributions as the sole shareholder of his firm. The IRS determined that the CPA had not paid himself a reasonable salary and treated $175,000 of his distribution as salary subject to payroll tax. 105 AFTR 2d ¶ 2010908.)

    How S Corporation Shareholders Receive Profits

    S-Corporation Tax Calculator [Spreadsheet]–When & How the S-corp Can SAVE TAXES vs. Sole-Proprietor

    There are two ways S corporation shareholders get profits. The profits can be received as a distribution or as a salary. Passive investors who don’t serve as officers or work for the corporation typically receive a distribution. If you’re working in the business, you have to receive at least part of the profits as salary.

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    It Lets You Write Off Your Salary Which Lowers Your Payroll Taxes

    Per the IRS, S corp owners are required to pay themselves a reasonable salary as an employee of their company. Being paid as an employee means that your wages are subject to the Federal Insurance Contributions Act payroll tax withholdings AND the S corp must also pay employer payroll taxes.

    Youre probably thinking, I thought you said I was going to save money on taxesnot pay more! Bear with me.

    When youre paid a salary via payroll, two very cool things happen:

    • Your taxes are taken directly out of your paycheck. Instead of getting a giant tax bill at the end of the year, your taxes are deducted every time you get paid. Plus, instead of footing the entire tax bill all at once, your S corp pays for half of your FICA payroll taxes throughout the year, making your year-end taxes way easier to manage.
    • Your employee payroll taxes and wages are a deduction for the company. Your salary is a write-off for the corporation which lowers your overall profits which lowers your taxes. Thats because youre taxed on those profits, so when theyre lower, you pay less.

    Recap:

    • When you pay yourself a salary from your S corp, the personal you gets paid.
    • Your income and payroll taxes are deducted directly from your paycheck.
    • Your S corp writes off your salary and its portion of your payroll taxes, which reduces your year-end taxable profits.

    Now that youre stoked on getting a paycheck from your business, lets talk about how you get taxed on the profits from your S corp.

    When Should Your Company Become An S

    An LLC owner might want to become an S-corp for the tax advantages while avoiding dealing with the state law formalities of corporations, which would require having officers, directors, board meetings and board minutes.

    It could be a good time to consider becoming an S-corp when the company generates enough profit to make the change in tax structure worth it.

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    A Special Tax Deduction For S Corp Owners

    Like other pass-through businesses, S corporation owners may be eligible to take a Qualified Business Income Deduction to deduct up to 20% of their business income . This deduction is in addition to the normal business expense deductions the S corporation can use to reduce its taxes. The QBI deduction is taken based off the owner’s tax return, not the business’ return.

    Reasonable Compensation History: No Salary Taken

    Before Tax

    In light of these potential employment tax savings, the IRS has long challenged attempts by shareholder-employees to minimize compensation in favor of distributions. The IRS opened its attack on these perceived abuses in Rev. Rul. 74-44.8 In the ruling, the IRS imputed the payment of reasonable salaries to an S corporation that paid dividends but no compensation to two shareholders who provided services to the corporation.

    Fifteen years later, an oft-cited decision further clarified the IRSs position on reasonable compensation. In Radtke,9 the taxpayer was the sole shareholder and director of a law firm established as an S corporation. Although the taxpayer devoted all his working time to the law firm, he took no compensation for the year at issue, opting instead to withdraw $18,225 in dividends.

    The IRS argued, and the district court agreed, that the dividends represented wages subject to payroll taxes, with the court adding, where the corporations only director had the corporation pay himself, the only significant employee, no salary for substantial services . . . is dividends functioned as remuneration for employment.

    Spicer had an arrangement with his corporation whereby he donated his services to the corporation in exchange for no compensation, and as a stockholder he withdrew his earnings as distributions. Accordingly, Spicer did not pay payroll taxes on the amounts he received.

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