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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.
What is an S-corp?
An S-corp is a corporation with a specific tax setup. Unlike a sole proprietorship or partnership where you are personally liable for business debts, an S-corp is a legally separate entity from its owner. S-corps provide you with a layer of protection for your personal assets in the event that your business can’t pay its debts or your business is sued.
While partnerships and limited liability companies (known as LLCs) require certain owners and partners to pay self-employment taxes, an S-corp does not. Instead, employees of S-corps have employment taxes withheld from their paychecks.
One of the primary benefits of an S-corp is tax savings. With a C corporation, profits are reported on the company’s tax return and then again on shareholders’ tax returns as dividends. This means the profits are taxed twice. However, an S-corp doesn't pay federal corporate taxes; instead, it passes its profits or losses onto the shareholders to file on their personal tax returns.
Ways to pay yourself as an S-corp
Owners of S-corps who have a hand in daily operations fill two roles: one as a shareholder and another as an employee. However, owners who do not oversee daily operations are classified only as shareholders. The role you play in your company directly affects how you can pay yourself under the S-corp structure and which restrictions apply.
When it makes sense: You work at your company.
If you work in the company as an employee, you need to receive compensation that allows you to pay employment taxes to the IRS. This is a requirement regardless of other forms of compensation that you receive as a shareholder, such as distributions. Such compensation is traditionally paid as a salary so that employment taxes are properly reported.
The IRS requires S-corp employees to be paid reasonable compensation, an amount comparable to what is paid by organizations in the same industry for similar work and experience.
For S-corps, this means you must ensure that you are paid compensation that is not so low as to avoid paying required taxes and is comparable to the salary of officers with your experience at similar businesses. While some S-corp owners have reduced their federal income taxes by paying themselves a low salary and taking the majority of their income in the form of distributions, this tactic is viewed by the government as an attempt to sidestep taxes.
If the IRS determines that a shareholder's salary does not qualify as reasonable compensation, the S-corp can be penalized for neglecting to withhold and deposit employment taxes, in addition to being required to pay back taxes on what was not reported.
When it makes sense: You own a business but aren't involved in day-to-day operations.
If you own an S-corp that's profitable and has more than enough cash to cover future expenses, it's also possible to receive compensation by taking distributions. These are payments of earnings to shareholders, usually in the form of cash or stock.
If you’re not active in your company’s operations and don’t provide services to the S-corp, you can receive compensation as distributions rather than a salary. The primary difference between a salary and distributions is that distributions are not subject to employment taxes. However, they are considered part of a shareholder’s personal income for tax purposes.
These distributions are tax-free until they exceed a shareholder's stock basis; beyond that point, they are taxable. The stock basis is the shareholder's initial investment in the business, which may be decreased by certain business losses or increased through business income.
Some business structures allow an owner’s draw — the ability for an owner to withdraw funds from the company for personal use — but S-corps are not allowed to do so. Distributions take the place of an owner’s draw with S-corps.
Salary and distributions
When it makes sense: You work at your company and want part of your compensation to be based on the business's performance.
If you're an owner and shareholder-employee, you can also take distributions in addition to your salary when the business is doing well. Such distributions aren't subject to employment taxes, as long as your salary meets the reasonable compensation standard. However, if that standard isn't met, the IRS can reclassify other compensation as taxable income.
Before choosing this option, it's a good idea to consult with an accountant to understand the requirements of reasonable compensation.