f you’re considering switching to S Corp taxation, it’s important to understand how S Corp distributions work. S Corp distributions are the method small business owners use to get paid while lowering their self-employment tax liability. Here’s a look at how S Corp distributions work and how they can help you take more control over your tax bill.
Understanding S Corp distributions
When you own an S Corp or an LLC taxed as an S Corp, you’re paid in two different ways. First, you receive a regular salary for the work you do for your business. Second, you get a distribution for profits your company generates.
Salaries are often best handled through a payroll service that automatically handles your regular paychecks, payroll taxes, and business tax filings with the IRS and state tax authorities. Your salary is subject to the self-employment tax, which comprises both the employee and employer portions of your payroll tax, plus income taxes.
Remaining business profits are paid out on any schedule you choose and are only subject to regular income tax. Because you don’t have to pay self-employment taxes on your profit distributions, they’re charged a lower total tax rate than your salary.
As a shareholder of an S Corporation, your income is a form of non-dividend distributions, so its not subject to capital gains tax. For tax purposes, distributions are part of your ordinary income.
How S Corp distributions work
When you operate a business, you’re hopefully earning a profit. If you operate as a sole proprietorship or standard LLC, all income you generate from the business is subject to self-employment taxes.
While self-employment taxes are simply a cost of doing business for many, business owners earning around $80,000 per year can save when filing their income tax return by splitting their pay into salary and shareholder distributions.
Because business income is irregular, you don’t have to pay yourself distributions on a particular schedule. You can make withdrawals to pay yourself from your business bank account to your personal bank account at any time, as long as you have enough funds left over for your salary and business operations.
Tip: Shareholder dividends are different from owner distributions. Dividends apply to C Corporations. Distributions apply to S Corps. If you operate your business as a C Corp, you’re likely a victim of double taxation.
Tax implications of S Corp distributions
Every dollar you earn as a distribution, rather than salary, is taxed as ordinary income. In most cases, that means a lower tax rate. To better understand how it works, here’s an example. Let’s assume your business earns $100,000 annually, and you take $60,000 per year as a salary.
The $60,000 salary is subject to both income taxes and self-employment taxes. The total self-employment tax rate is 15.3%. Your income taxes depend on your income rate, but we’ll assume 25% for simplicity. In this case, you would pay $9,180 in self-employment taxes and $15,000 in income tax. Half of the self employment tax would be paid by your S Corp and deducted.
The remaining $40,000 in business income wouldn’t be subject to self-employment taxes. You would pay only the 25% income tax on that portion of your income, or $10,000, leaving you with $30,000 after federal taxes.
If you were a plain old LLC without the benefits of S Corp taxation, the entire $100,000 would be subject to the 15.3% self-employment tax and 25% income tax. Thanks to an S Corp, $40,000 of your income is taxed at a lower rate.
It’s also worth noting that your distributions don’t count as Social Security income and, therefore, won’t contribute to growing your Social Security in retirement. But when you do the math on tax savings, you’ll typically find the benefits of an S Corp outweigh the lower Social Security income.
Potential pitfalls and risks
Now you might be thinking, why don’t I skip the salary and pay myself entirely with distributions? The simple answer is that the IRS won’t allow it. IRS regulations require you to pay yourself a reasonable salary.
There are no set standards for what constitutes as reasonable and it is a facts and circumstances test that applies differently to each person. You can consider total business profit, where you live, and the salary for similar positions but no single factor is determinative.
If you pay yourself too little, you could be audited by the IRS. If the tax agency determines that you don’t pay yourself a reasonable salary, you could be subject to back taxes, plus interest and potentially penalties, for the amount the IRS deems you underpaid yourself.
Strategic use of S Corp distributions
To get an S Corp’s tax benefits, finding the right balance between salary and distributions is important. Due to the risks described above, business owners are wise to resist the temptation to pay themselves too little.
To make the best use of S Corp distributions, it’s a good idea to grow your salary over time, just as many large companies do, with annual raises. Consider giving yourself a performance review to ensure your salary is reasonable for your work. If you can find the right salary for your role as a solo business owner, you can confidently move forward and work to grow your profits, knowing you’re making the best decisions for your business taxes.
Frequently Asked Questions (FAQs)
When are S Corp distributions taxable?
Can S Corp distributions be unequal?
S Corp distributions don’t have to be the same amount each time. Distributions can be for unequal amounts. As business income fluctuates, distributions may also fluctuate.
Why are S Corp distributions not taxable?
Contrary to the belief of some, S Corp distributions are taxable. While they’re not subject to self-employment taxes, you must pay taxes on distributions at your regular income tax rate. According to IRS rules, small business income isn’t tax-free income.
Where are S Corp distributions reported?
S Corp distributions are included on your business’s Form 1120S. You’ll receive a Schedule K-1, which is used to pay taxes when filing your individual income tax return. Because S Corporation earnings are paid through your personal income tax return, this type of business entity is considered a pass-through entity.
Eric Rosenberg is a finance, travel, and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full-time. You can connect with him at Personal Profitability or EricRosenberg.com.