S corporations are a unique type of business entity that combines organizational features similar to a sole proprietorship or partnership, plus corporate protection. The entity essentially operates as a corporation, but year-end profits and losses pass through to shareholders and are treated as individual income tax items. This means the corporation itself does not pay corporate income tax, thus eliminating the double taxation that makes regular C corporation structures unattractive. Another unique feature is the ability for shareholders to receive distributions of profit in addition to regular salary.
S corporation officers must receive a salary. The compensation does not have to equal a specific amount, but should be an amount that is normal for the services an officer provides to the company. Salary amounts may fluctuate as the business grows. It is normal for an officer to receive a minimal salary in the beginning stages of a company’s growth, and progress to a higher salary in later years. Officer salaries are subject to regular federal income, Social Security and Medicare taxes. As a W-2 employee, S corporation officers have an easier time proving income for personal financial reasons. In addition, the company receives the benefit of deducting the salary and taxes paid on behalf of an officer as business expenses.
Distributions of profit to shareholders are not included in salary payments, and are not subject to payroll tax. There is no limit to the amount of distributions an officer may receive, however the IRS cautions that excessive distributions may be considered income and treated as compensation subject to payroll tax. For example, if an officer receives $8,000 annual salary and $75,000 in distributions, the distributions are considered excessive in relation to the salary. Many accountants recommend that distributions not exceed 40 percent of an officer’s S corporation salary. Since the IRS does not confirm a percentage threshold, discuss a reasonable figure with your accountant.
A huge tax benefit of S corporation distributions is that the distributions are business expenses. Distribution amounts are deducted from the company’s gross income, which reduces the net income of the S corporation. Because S corporation net income is the amount that transfers to shareholders on the individual level, shareholders may essentially receive distribution income tax free. When distributions are not taken and the S corporation realizes a net profit at the end of the year, shareholders pay individual income tax on the amount. At times, it is beneficial to review corporate financial statements just before the tax year ends. Your accountant may advise you of potential net income and whether a profit distribution before year-end is best.
Many S corporation shareholders are attracted to the tax savings the S corporation structure offers, but some considerations must be made. If an officer of the corporation wishes to purchase an asset that requires financing (such as a home), it is more beneficial to receive a higher salary in lieu of excess distributions. This may not provide as many tax benefits, but because distributions do not appear as income on a 1040 income tax return, an officer may have a difficult time proving income when the income isn’t reported on individual documents. In addition, the S corporation must consider its lending needs. If the business anticipates requesting a loan, it is more favorable for a bank to see corporate profits. In this case, an S corporation may not want to distribute all its profit to shareholders.