In the world of business entities, there are two types of corporations: C Corps, which include your traditional large companies, and S Corps, which are synonymous with small businesses. S Corps must have less than 100 shareholders. Shareholders can be individuals and certain trusts, estates and LLCs—not IRAs, other corporations, partnerships, etc. Additionally, S Corps must only offer one class of stock. However, the most significant difference is the tax treatment of earnings.
C Corps pay tax on their earnings. If a C Corp then chooses to pay dividends to the shareholder, those are made on an after-tax basis for the company. Dividends are then taxed again at the individual level. This is commonly known as the double taxation that C Corps are subject to. S Corps, on the other hand, are pass through entities, meaning, any income or loss, tax credits or deductions, and capital gains or losses are passed through to the shareholders. Additionally, whatever is passed through retains its characteristics, so if it is a long-term gain, the individual then pays long-term capital gains tax rates.
Unlike C Corps, S Corps can pay distributions, which generally are not subject to Social Security and Medicare withholding tax, which can equal a significant tax savings. Let’s say you own an S Corp and you pay yourself a salary of $118,500, which just happens to be the wage base for Social Security taxes in 2016. You will pay Federal Insurance Contributions Act (FICA) federal payroll taxes as both an employee and an employer to fund Social Security and Medicare, a total of 15.3%, which amounts to $18,130. Now, if you chose to reduce your salary to $60,000, you and the company would pay $9,180 in taxes. You could then take $58,500 in distributions that would not be subject to FICA taxes.
With potentially $8,950 less being paid into the Social Security and Medicare funds, the IRS takes a special interest in what S Corp owners pay themselves as a salary. The general rule is S Corp owners have to pay themselves a reasonable salary, which is generally based on your experience, training and position in the business; how well the business is doing; the prevailing compensation rates for other businesses in your industry; your salary compared to other employees, and other factors. Through your reporting, the IRS knows most of this information, and if your salary falls below the acceptable range, the IRS computers may flag you for an audit.
The IRS also knows that business can be cyclical. One year when the company is doing well, you may pay yourself a normal salary and take little to nothing in the way of distributions. Other years, when the business is struggling, you may significantly reduce your salary and take more in distributions from profits that you’ve already paid taxes on. The IRS has allowances for such situations.
Overall, tax planning is a necessity for S Corp owners so they do not run afoul of what the IRS deems reasonable. It is also beneficial that S Corp owners work with a financial adviser to determine long-term goals, as retirement savings are based on the salary they pay themselves.
If you have questions regarding your ownership in an S Corp and what should be a reasonable salary for you, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
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