The two ways to take earnings out of an S corporation are either as earned wages required when corporate officers perform services for the company or as shareholder distributions. Profits are attributed to shareholders at the same percentage as each shareholder’s percentage of ownership interest. Wages paid to shareholders must meet a “reasonable” standard required by the Internal Revenue Service.
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1.
Investigate the level of wages in the industry in which your company operates by checking sources such as trade associations, chambers of commerce, industry reporting services or your own network of professional colleagues. The IRS provides no specific guidelines as to what is a reasonable wage but notes factors considered by courts when ruling on the matter have included training, experience, duties, dividend history and time and effort devoted to the business.
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2.
Set the wage for any officer or shareholder who provides substantive services to the company, either full or part time. The IRS cites court rulings that have found any officer or shareholder who provides more than a minor service to an S corporation must receive a wage rather than report all compensation as distribution of profit shares in an attempt to avoid paying employment taxes.
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3.
Withhold income tax and Federal Insurance Contribution Act taxes based on information provided on each employee’s W-4. FICA withholding for Medicare and Social Security as of 2010 amounts to 7.65 percent of an employee’s wage, and the S corporation as an employer contributes an equal amount. The corporation must also pay federal and state unemployment taxes. Payments under the Federal Unemployment Tax Act are set as of 2010 at 2.6 percent but only apply to the first $7,000 paid to each employee. Make payments of withholding and company share of employment taxes using IRS Form 941, Employer’s Quarterly Federal Tax Return and equivalent state forms.
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4.
Deduct wages and the S corporation’s share of employment taxes paid on corporate officer wages as a business expense from the company’s gross profit on IRS corporate tax form 1120S.
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Report each shareholder’s pro rata share of the S corporation’s net profit on schedule K1 of form 1120S. The corporation’s entire net profit is divided for tax purposes among each shareholder and reported as passive income on each shareholder’s personal return. Passive income is not subject to employment taxes, even that portion of profit attributed to shareholders who also receive a wage from the company.
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6.
Distribute portions of the S corporation’s profits in a manner allowed by your company’s bylaws. While shareholders pay income tax on their entire share of profit, any actual distribution of profit does not incur an additional tax.
Certainly! I've got quite a bit of expertise in this area, especially regarding S corporations, taxation, and the intricacies of shareholder distributions versus earned wages.
The concept revolves around the dual modes of extracting earnings from an S corporation: one being earned wages for services rendered by corporate officers, and the other being shareholder distributions, which are tied to ownership interests.
Let's break down the components mentioned in the article:
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Investigating Industry Wages:
- It's crucial to benchmark wages within your industry, and sources like trade associations, industry reports, or professional networks can offer valuable insights.
- The IRS doesn't provide precise guidelines for "reasonable" wages but considers various factors: training, experience, duties, dividend history, and time devoted to the business.
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Setting Wages for Substantive Services:
- Officers or shareholders providing significant services must receive a wage, not solely distribute profits to avoid employment taxes.
- Court rulings support the notion that substantial service warrants wages rather than treating all compensation as profit distribution.
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Tax Withholding and Contributions:
- Income tax and FICA taxes (Medicare and Social Security) are withheld based on W-4 information.
- FICA withholding amounts to 7.65% of an employee’s wage, with the corporation matching this contribution. Additionally, federal and state unemployment taxes apply.
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Deducting Wages and Employment Taxes:
- Wages and the S corporation’s share of employment taxes paid for corporate officers are deductible business expenses on Form 1120S.
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Reporting Profits to Shareholders:
- Shareholders receive their share of the S corporation’s net profit on Schedule K1 of Form 1120S. This entire net profit is divided among shareholders for tax purposes, appearing as passive income on personal returns.
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Profit Distributions and Tax Implications:
- The S corporation can distribute profits according to its bylaws. Shareholders pay income tax on their entire share of profit, but actual profit distribution doesn’t incur additional taxes.
These concepts are integral to effectively managing an S corporation's finances, adhering to IRS regulations, and ensuring equitable treatment of shareholder earnings and compensation for services rendered.
