By Jason Watson
Updated September 29, 2014
This KB article has been re-written. Please use the following link-
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As an S-Corp, you are taking money out of the business in four ways-
| Source | Payroll Taxes | Income Taxes |
| Wages | Yes | Yes |
| Shareholder Distributions | No | Yes |
| Rent (not home office) | No | Yes |
| Reimbursements (accountable plan, health expenses, education assistance) | No | No |
Remember, payroll taxes (Social Security and Medicare taxes) are the same as self-employment taxes.
When you write a check to yourself you are taking a shareholder distribution. And even if you don’t actually write a check, and the cash remains in the S-Corp, it will be reported as income on your K-1. Read that again. Here is a story to drive home this point- WCG (formerly Watson CPA Group) has an S Corp client who accumulated about $400,000 in her business checking account over the years. No big deal. Her husband called and wanted to know the tax consequences of moving the $400k into their personal checking account since they were buying a house. We said None. You already paid taxes on the income that aggregated to $400,000 over the past three years.
Another way to look at this- cash that you take out (shareholder distributions, dividends, owner draws, whatever you want to call them) is NOT considered when determining your taxable income. Cash is cash and income is income. Sure, in most cash-based businesses, cash will equal income and income will equal cash. But there can be a difference when factoring in non-cash expenses such as mileage and depreciation. And the opposite with non-expense items such as principal debt service.
Yet another example. Sorry to belabor this issue, but it appears this income versus cash continues to frustrate small business owners. Ok. Let’s say your S Corporation earns $100,000 after expenses, and you magically also have $100,000 in the business checking account. You transfer $50,000 to your personal checking account.
What is your taxable income? $100,000. Good.
Next year, your business is a bit slower and you only earn $50,000 and therefore you have $100,000 in the business checking account. You transfer $90,000 to your personal account leaving $10,000 in the business account.
What is your taxable income? $50,000 even though you transferred $90,000 from the business to you. Cash is cash and income is income.
A bit off-topic.. back to determining the payroll amount- as you might be aware shareholder distributions are only taxed at the income tax level and not subjected to payroll taxes such as Social Security, Medicare, unemployment or disability taxes. This is one of the reasons you are using an S-Corp election.
And any personal expenses that you have the company pay directly are also considered shareholder distributions. For example, if the company writes a check to pay for your shopping spree at Banana Republic, this essentially is the same as the company writing you a check and then you write a check to Banana Republic. But this is a bad bad habit. Comingling money and comingling expenses is not the best move.
The big question becomes what to pay yourself as a wage. The amount of wages can change quarterly depending on your quarterly profit levels. While your particular situation might warrant further discussion, a good place to start is half of your net profits being paid as wages. If your income is routine or consistent, then you can also elect to pay a strict annual wage on a quarterly basis.
Set It, Forget It, Sort Of
While payroll can fluctuate per quarter, it usually makes more sense to establish a payroll figure in the beginning of the year. Payroll is run for Q1 and Q2 based on gross income, expenses, and net income assumptions and subsequent projections This will be similar to a set it and forget it system. Remember, this is not an exact science, nor does it need to be.
Next, we will consult with you in August or September for a mid-course correction or tune-up for Q3, and then again in November to make sure everything is close to being on pace for Q4. While accountants attempt to be penny-perfect, the determination of S Corporation payroll is more of an art.
Competing Interests
The 50% salary is just a jumping-off point. There are several factors that need to be considered and they can be competing. For example, you want a small salary to keep your Social Security and Medicare taxes low. But not too small when compared to your peers earn in the same profession.
You might want a higher salary to add to your Social Security basis. The first bend point is about $56,000 and the second is $94,000 which are indexed each year for inflation. The first bend point means that you are getting the most credit for the least amount of salary, and it decelerates after $56,000 and almost hits a cliff at $94,000. And as you recall, $117,000 is the maximum wage where Social Security is taxed.
You also might want a higher salary because of your SEP IRA contribution. You may contribute up to 25% of your salary to your SEP IRA. Similarly with a 401k. You can contribute up to $17,500 (plus $5,500 catchup if 50 or older). So, if you are 55 years old you might want your salary to be $23,000. There is also another consideration when it comes to profit-sharing contributions by the company which is also limited to 25% of your salary. Check out the Small Biz Retirement Supplement at the end for more details.
Another competing interest, or at least a factor, is health insurance and HSA contributions.
Confused yet? No surprise since there are many variables to consider to ensure all your needs and wants are being met. Call WCG (formerly Watson CPA Group). We can model each scenario and provide net-net results given different salaries and goals.
Two Methods
There are two methods of paying wages- one is forward-looking and one is backward-looking. The forward-looking method is to establish the quarterly wage, and write that check separately to the shareholder(s) with the associated taxes withheld. The backward-looking method is to continue to take shareholder distributions on a consistent basis (daily, weekly, monthly, etc.). Just like any other investment and subsequent dividend checks, you are free to use that money for your living expenses. Then, those monies are reclassified as either wages or shareholder distributions, and the taxes associated with the reclassified wages are processed, filed, and paid.
Remember, an S-Corp is taxed on its net income. Whether the cash sits in the business checking account or is paid out as a distribution to the shareholders, it will be taxed. This the pass-thru nature of an S-Corp.
If you have other W-2 income from another job or employer, more discussion is required to minimize tax consequences. Since each job doesn’t know about the other, taxes withheld will be based on just one income and not two. We strongly suggest keeping W-4 exemptions very low or zero on the lower-income until some history is built and you can manage expectations.
Taxpayer’s Comprehensive Guide to LLCs and S Corps : 2019 Edition
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