S Corps and Shareholder Distributions
Why Elect S Corp Status for my Business?
Being in Winter Haven, we’ve seen the growth of business and commerce over the last decade. From the revitalization of downtown Winter Haven to the expansion of business activity on Cypress Gardens Boulevard due to the presence of the Legoland Florida location, this is a great time to be a Winter Haven resident and a great time to be a Winter Haven business owner. This recent growth and development in Winter Haven have been a key contributor for many to make the choice of converting from employee to entrepreneur. Most will excitedly get the business going, file as an LLC with the State, apply for an EIN with the IRS, open a bank account, and start pushing for clients. It’s not usually until the end of the year, or the beginning of the next year, that the new business owner will want to start thinking about filing income taxes for their new business venture – but who ever really gets excited thinking about filing income taxes? It’s then they come to their CPA, with the same questions: ‘Should I file as an LLC on my Schedule C? Should I file as a Partnership? S Corp? C Corp?’ These questions aren’t sexy. New entrepreneurs love talking about their new product or their market demographics. It’s usually secondary to start planning which business structure to use. However, it’s a necessary evil to make a decision regarding business structure, and it’s a decision that will have major income tax implications.
What are the tax benefits of electing S Corp status?
The purpose of this article is not to delve deep into the differences of each business structure available, but to pinpoint some of the key benefits of electing S Corp status. For sole proprietorships and small businesses, the S corporation is often the most attractive business structure for tax planning strategies. ‘So why elect S Corp status if I’m a sole proprietorship? It sounds like a ploy for my CPA to rack up more tax preparation fees.’ CPAs often encourage the S Corp status because of the ability of an S Corp shareholder to payout retained earnings via shareholder distributions in addition to wages. This a unique trait of the S Corp business structure. When an LLC owner files the LLC’s income on their personal income tax return via Schedule C, all of the business activity’s net income is subject to their individual income tax rate and self-employment tax (which is essentially the employee and employer portion of FICA taxes due on that income). When a shareholder of an S corporation takes a payout of retained earnings in the form of wages, the same tax situation occurs as on the Schedule C – just at a different timing. FICA taxes will be withheld from the shareholder’s gross pay and the corporation with pay in the employee and employer portion of FICA taxes due on the shareholder’s wages. However, when a shareholder takes a payout of retained earnings in the form of a shareholder’s distribution no FICA taxes are due on the payment. The distribution will not affect income tax as it is treated just as a reduction of retained earnings and not as an expense that reduces net income.
For example, Mike is an owner of an S Corporation. Mike, with the recommendation of his CPA, decides to write himself a check for a $50,000 shareholder distribution. The payment is not an expense that will reduce net income as it would if the payment were paid out in the form of wages. Wages of $50,000 would reduce the S Corp’s net income by that amount, but this payout would show up as taxable wages on the shareholder’s W-2 at year end. The payment as a distribution does not reduce net income of the S corporation, so instead of flowing through as W-2 wages it will flow through as business income from an S Corp. However, the key difference is the treatment of the payment types for FICA tax purposes. Wages or a bonus will incur additional FICA taxes, but the shareholder distribution is not subject to FICA taxes. A $50,000 shareholder distribution instead of a bonus on wages of $50,000 would create tax savings in excess of $7,000 – but there a plethora of rules and limitations on the timing and payout amount of distributions in relation to officer’s compensation as wages. If you’re interested in discussing in more depth, please reach out to Josh Conner at jconner@conner-cpa.com or at (863) 268-4374 to see if the S Corp business structure is right for your situation.