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Take Money Out of the S Corp
By Jason Watson, CPA
Posted Sunday, October 10, 2021
Remember, payroll taxes (Social Security and Medicare taxes) are the same as self-employment taxes. But they also include unemployment taxes, state disability insurance (such as California’s state disability insurance) and other odd-duck local taxes. We discussed this in previous chapter.
As an S Corp shareholder, you are taking money out of the business in various ways-
|Source||Payroll Taxes||Income Taxes|
|Reasonable S Corp Salary||Yes||Yes|
|Reimbursements (Accountable Plan)||No||No|
|Funding Retirement Accounts||No||Deferred|
|Self-Rental (not home office)||No||Maybe|
|Adding Children to Payroll||Yes||No|
Reasonable S Corp Salary
This is a bit obvious, right? Paying yourself a reasonable shareholder salary is a quick way to pull money out of the business. We’ve already touched on reasonable salary theories in an earlier chapter. We will explain payroll processing, tax planning, withholdings and cadence in a bit.
Shareholder Distributions (versus Income)
When you write a check to yourself or transfer money from your business checking account to your personal checking account, you are taking a shareholder distribution. However, you are not taxed on shareholder distributions nor are they a deduction to the business- you are taxed on income (net ordinary business income after expenses and deductions).
Here is a story to drive home this point- WCG has an S Corp client who had accumulated about $400,000 in her business checking account over the years. No big deal. Cash is king, right? Her husband called and wanted to know the tax consequences of moving the $400,000 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. Huh?
Let’s say your S Corporation earns $100,000 after shareholder wages and expenses, and you magically also have $100,000 in the business checking account. You transfer $60,000 to your personal checking account as a shareholder distribution. $40,000 is left behind in the business 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 $90,000 ($40,000 + $50,000) in the business checking account. You transfer $80,000 to your personal account leaving $10,000 in the business account.
What is your taxable income? $50,000 even though you transferred $80,000 from the business to you. Cash is cash and income is income. As mentioned earlier, over time, aggregated historical cash should be very close to aggregated historical incomes for a stable business. This is mostly true even after accounting for depreciation since this is a mechanism to offset cash outflow for purchases.
This cash is cash and income is income thing can be a real bummer at tax time too. For example, you have $100,000 left over at the end of the year and your taxable income is coincidentally $100,000. You took $70,000 in shareholder distributions as a return on your investment, leaving $30,000 behind for business growth (the reinvestment).
If you are taxed at 24%, you will pay $24,000 ($100,000 x 24%) in taxes on $70,000 worth of net economic benefit from your business- suddenly this becomes painful and a near-35% tax rate ($24,000 divided by $70,000). Something to think about. Keep in mind that this is short-term pain since you are growing your business and hopefully increasing your net economic benefit from it (and adding to your shareholder basis which reduces capital gains should you sell).
We have more information about shareholder distributions including cadence in another section.
Reimbursements (Accountable Plan)
We encourage businesses to create an Accountable Plan which allows employees to turn in expense reports for various reimbursable items. The typical reimbursed expenses through an Accountable Plan are home office use including depreciation, mileage or business-use portion of automobile expenses, cell phone and internet.
All these expenses have one thing in common- they are mixed used, both personally and business. Mixed-use expenses should be paid by the employee and later reimbursed. Conversely, anything that is 100% business use should be paid directly by the business.
This is also expanded in a later section with some fun journal entries too, Exciting!
Funding Retirement Accounts
Not only can you make contributions to retirement accounts, the business can also fund your SEP IRA, solo 401k plan, profit sharing plan, defined benefits plan, cash balance plan, and other retirement plan mechanisms. We have a whole chapter dedicated to retirement planning within your small business.
We’ve already discussed self-rentals and how you can pull money out that is only taxed at the income tax level. Here is a re-print of that information-
It is common for a business owner who relies on machinery or equipment to have two business entities. One entity is an LLC that owns the assets. The other entity is an S corporation which leases the assets from the LLC to use in the business. This directly reduces the S Corp’s net operating business income, and might possibly reduce the amount of salary required to be paid by the business to the shareholders. Good news.
Here is an example-
|S Corp Owns Building||LLC Owns Building
S Corp Rents from LLC
|Reasonable Salary (assumed at 40%)||40,000||28,000|
This is an overly simplified example and leaves out depreciation, etc., but you get the idea. In addition, we used a 40% salary calculation simply for the sake of presentation. Your actual salary might be different in your situation. Regardless, the apples to apples comparison shows a nice little savings of $1,692. As mentioned in a previous chapter, the arrangement also allows you to have different partners in each entity allowing you to expand ownership in the operating entity while retaining full ownership in the leased asset (building).
Here is another self-rental situation. You find a business connection for renting space in your home for 14 days or fewer. Client parties and presentations are good examples. Board meetings for closely held businesses is a bad example (or at least one that is tough to defend). Your business enters into a lease arrangement at market rates. The business deducts the amounts paid as rent and issues a 1099-MSIC to you. On your tax return, the amount of rent is reduced to zero with a one-time expense adjustment under Section 280A in the amount of rent.
Adding Children to Payroll
This is another tool in the toolbox to pull money out of your S Corp. You pay your child $12,600 or whatever the standard deduction is for that tax year and they spend it on college or gift the money back to you (or they fund a Roth IRA and save the rest for their first home). This is a deduction to you at your tax rate but is tax-free to the child. However, the child pays 7.65% in Social Security and Medicare taxes and the S Corp pays the same.
Additionally, the parents might lose child tax credits. Therefore, this usually works well when the parents tax rate is 32% or higher to provide a large enough delta between 15.3% (mandatory payroll taxes) and the parent’s tax rate plus tax credit considerations (since chores are a snap, why not have them work too?).
We expand on this more a bit later, but you can also read our Reducing Taxes summary article here-
These are generally frowned up. To truly be a shareholder loan where the S Corp lends money to the shareholder, there must be loan terms including payment, amortization and imputed interest. Shareholder loans have a purpose, but it is narrow and must be carefully implemented.
Jason Watson, CPA, is a Senior Partner of WCG, Inc., a boutique yet progressive tax and
consultation firm located in Colorado and South Dakota serving clients worldwide.
Taxpayer's Comprehensive Guide to LLCs and S Corps 2021-2022 Edition
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Taxpayer's Comprehensive Guide to LLCs and S Corps 2021-2022 Edition