S Corp Taxes: Everything You Need to Know
Before you learn about s corp taxes, you must be aware of how the tax structure works.6 min read
2. Figuring Out a “Reasonable Salary”
3. Additional S-corporations Costs
4. S-corps Taxation
6. Cost Basis of S-corporation
7. Dual Tax Burden of S Corporations
8. Taxation Types
9. Passive Income
What are S Corp Taxes?
Before you learn about s corp taxes, you must be aware of how the tax structure works. First, self-employed individuals should file as an S-corporation to avoid paying high Medicare and Social Security taxes. Self-employed individuals must pay high taxes known as self-employment, but an S-corporation keeps your taxes to a minimum. However, the IRS may scrutinize your tax returns more closely if you go the S route, as your tax liability will be inevitably lowered. In addition, abuse of this system commonplace, which is why your return may be looked at closer by tax authorities. For example, you may trigger an investigation if you make $100,000 but only declare $20,000 as salary income.
Regardless of how much you pay, you need to pay Medicare and Social Security taxes.
When you’re employed, you only pay a portion of Medicare and SS taxes while your employer pays the rest. Since self-employed persons have no employer to pick up the up tab, an S corporation allows you to designate a portion of your income as a salary and another as distribution. You should try to declare a reasonable amount of income as a wage instead of a distribution. You must still pay self-employment taxes on the salary end, but you’ll only pay standard income tax on the distribution part. Dividing the income can save you a great deal of money.
Additionally, S-shareholders do not need to pay self-employment taxes on their portion of business profits. With that, every owner working as an employee is owed some form of compensation in the form of a salary, and the salary is subject to Medicare and Social Security taxation. The salary that is taxed is paid half by the corporation and another half by the employee.
The threshold for what is considered reasonable is up for debate, but avoid declaring too much of your income to avoid an audit. You could end up paying penalties and interest on the taxes you owe.
Figuring Out a “Reasonable Salary”
The best way to determine a good salary is to visit salaray.com to search for the typical salary earned by people in a respective filed and geographic location. The IRS does not provide set guidelines on what constitutes a reasonable salary. However, the courts have considered the following factors when ruling:
- Responsibilities and duties of a shareholder employee
- Experience and training of shareholder employee
- Time and energy on the business.
- Portion of Dividends issued to shareholders
- Wages for non-shareholder employees
Additional S-corporations Costs
S corporations may end up costing you more than savings because of the continuous accounting and legal expenses. Your state may impose additional taxes and fees. For example, California levies a 1.5 percent business tax, but this requirement does not extend to sole proprietors. A sole proprietor is an individual who conducts business under a separate business name.
Like partnerships, S-corporations can use pass-through taxation. Pass-through taxation allows profits and losses to pass from the corporation to individual members, allowing them to declare the income on their taxes. The corporation is not taxed. With that, S corporations are also required to pay property taxes on any buildings owned. Additionally, S corporations need to honor state excise and sales taxes as any other business. Moreover, other states may impose:
- State Income Taxes
- Franchise Taxes
- Gross Receipts Taxes
You can check with your local Department of Revenue for more information on various forms of taxation in your state.
You need to Form 1120 to file your annual tax return. An annual return is a necessary document you must file. Failure to file could result in penalties and/or dissolution of your corporation. Further, Schedules K-1 and K reveal how the business income is divided between owners.
Cost Basis of S-corporation
Shareholders of an S corporation must pay taxes on their shore of business profits regardless of whether the profits were issued to them. Moreover, shareholders are not taxed on business income if those distribution do not surpass the cost basis of the business.
A cost basis is heighted by a shareholder’s portion of the business income, including any contributions made to the corporation. With that, the shareholder basis will be decreased by his or share of business losses and distributions received from the business.
For example: Bill created a business under S-corporation, contributing $40,000 cash to the corporation. During the year in which the business was created, the business paid Bill a salary of $30,000 after a regular business income of $20,000. During that year, the business also made a distribution to Bill of $25,000. When Bill created the corporation, the cost basis amounted to $40,000, which is the same amount he contributed to the company). The $20,000 regular business income increased the basis to $60,000, and the $25,000 distribution lowered the basis to $35,000. $35,000 is Bill’s cost basis near the end of the first year. The $30,000 salary will be made taxable to Bill as regular income, and it would be open to standard payroll taxes. The $20,000 regular business income is taxed to Bill as regular income, but it will be open to payroll or Medicare taxes. The $25,000 in distribution is not taxable to Bill because the cost basis before the distribution was more than $25,000.
Note: Each state has its own specific set of rules for S-Corp taxation.
Certain states model the tax structure on the federal model. Other states may directly tax the corporation instead. For example, Illinois levies a 1.5 percent tax on business income. Shareholders must also pay taxes on their portion of the income.
Dual Tax Burden of S Corporations
S-corporation must abide by certain tax guidelines:
- S-Corps are only permitted 100 shareholders
- Shareholder must be a U.S. citizen
- An active shareholder is classified as participating in everyday business operations. Passive shareholders do not. Active shareholders normally get two forms of income: profit distribution and wage
- S-Corp. owners must pay federal income taxes
Wage income is taxed under payroll taxes, while profit distribution is not open to payroll taxes. For example, an owner that gets $200,000, with half of it classified as wage income, that personal would pay $15,300 (15.3 percent taxed of $100,000). The remaining is exempt from payroll tax exemption. Wage income is taxed at 15.3 percent on the first $117,000.
Top marginal tax rates regarding active shareholders varies on if the last dollar is wage or profit.
Passive shareholders do not pay payroll taxes on income because they do not take wages from the business. Rather, they are subject to a Net Investment Income of 3.8 percent, which is applied to income over $200,000. ($250,000 for married couples)
Further, passive shareholders may pay high top marginal tax rates than active members.
S corporations are responsible for the following forms of taxation:
- Excess Net Passive Income
- LIFO Recapture Tax
- Built-in Gaines Tax
Net passive taxes and LIFO Recapture Tax applies to S corporations that were taxable as C corporations in the past. Further, the S corporation would face the same tax if it had gone through reorganization at the tax-free level.
Excess net passive income is a corporate tax on passive income of an S corporation. Passive income covers:
- Rents and Royalties
Net passive income taxes apply if the passive income is over 25 percent of gross receipts. The IRS gives worksheets to calculate excess net passive income tax with Form 1120S.
LIFO recapture tax is applicable when an S corporation applies the LIFO inventory pricing method of the previous tax year, or if the corporation moved LIFO inventory to the corporation in transaction that is not recognized.
LIFO means the first-out, last-in table of measuring inventory to figure out taxation.
The built-in gains tax is appropriate when the S corporation gets rid of an asset with in a five-year time frame of getting the asset. Moreover, the S corporation got the asset when it was under C status.
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