S Corporations can be a great way to reduce the amount of tax that you pay as a business owner. You can be treated as an S Corporation by the Internal Revenue Service (IRS) in a couple of different ways. You can choose to originally file as an S Corporation, or you can start a limited liability company (LLC) and file a Form 2553 to be treated as an S Corporation for tax purposes.
File Form 2553
Taking Earnings and Profits Out of an S Corporation
As a business owner, there are a couple of ways to take money out of an S Corporation:
- By paying yourself a “reasonable” salary
- By taking money out as a distribution, based on ownership in the company
It’s the difference between your salary amount and your distribution amount, which reduces the amount of tax that you owe.
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How an S Corporation Saves You Money
S Corporations reduce your taxes by lessening the amount of payroll or self-employment tax you pay. Money that you take out as a distribution is not subject to the 15.3 percent payroll or self-employment tax, whereas your regular salary payments are.
Taxes You Pay on S Corporation Salary and Payroll Earnings
S Corporations must have a payroll and salaried employees. Even if you’re running the business by yourself or with a spouse, you will still need to run payroll. You will pay several types of tax on any payroll amounts that you pay to employees or business owners:
- Employer payroll tax of 7.65 percent on payroll amounts earned
- Employee payroll tax of 7.65 percent on payroll amounts earned
- Federal income tax on payroll amounts earned after a standard deduction
- State income tax on payroll amounts earned after a state deduction
- Unemployment taxes payable to the IRS (FUTA) and your state (SUTA)
Taxes You Pay on S Corporation Distributions
Money that you don’t take out of your business as payroll can be taken out as a distribution. When you make a distribution from an S Corporation, anyone receiving a distribution will pay taxes as follows:
- Federal income tax on money distributed
- State income tax on money distributed
The biggest difference, and the advantage of being taxed as an S Corporation, is that you won’t pay self-employment or payroll tax on the distributions. This saves you a total of 15.3 percent on what you pay out as a distribution.
S Corp Tax Savings Calculator
Why You Can’t Just Pay Yourself Through S Corporation Distributions
Since you don’t pay payroll or self-employment tax on profit distributions, you might ask why you don’t just take all the money out as a distribution. The IRS is aware that business owners may try to do this and have rules in place to prevent it. If you breach these rules, you will need to pay penalties, extra taxes and interest.
The main rule is that you must pay any owners (or corporate officers) in the S Corporation a “reasonable salary.”
Defining a Reasonable Salary
Unfortunately, the IRS does not provide specific guidelines on what a “reasonable salary” is, but we can infer some guidelines.
- You should pay owners/corporate officers as much as they would reasonably earn performing the same role for another business.
- You should look at salary comparison websites like Glassdoor to see what people in similar roles are paid and make that a baseline.
- Take into account experience, length of time in the role and expertise when setting a salary.
S Corporation Distribution Rules
When you pay out distributions, you must pay them to owners/corporate officers based on their ownership in the business. This ownership could be set by the operating agreement, or by the issuance or purchase of shares in the business.
For example, if you pay out $50,000 in distributions and person A owns 50 percent of the S Corporation, person B owns 30 percent and person C owns 20 percent:
- Person A would receive $25,000 in distributions.
- Person B would receive $15,000 in distributions.
- Person C would receive $10,000 in distributions.
Reporting S Corporation Payroll and Distributions
You will need to report earnings and profits in several ways:
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This information is not intended to provide finance or tax advice, and everyone’s tax circumstances are different. Speak to a qualified accountant or tax preparer about your situation to ensure you get the right information and support to file and pay your taxes properly.
- Payroll returns need to be filed with the IRS and your state department of revenue.
End of year payroll returns like a W2 need to be filed with the proper agencies.
Payroll amounts will be reported on your Form 1120S.
Distributions are reported and filed on an 1120S and your personal tax return.