S-corporation profit retention is important for business, as you need to keep your shareholders happy and protect the investment they made. The law sees a corporation as a completely separate entity that has a perpetual existence as well as limited liability.

To form a corporation, a founder is required to file Articles of Incorporation with their state's secretary of state office. Once a corporation has been formed, they may file a Form 8553 to elect the tax designation of an S-corporation. In an S-corporation, each shareholders portion of the distribution will be taxed at the end of the year.

How to Distribute Net Profits Before Year's End for an S-Corp

When an S-corporation's net profits are distributed before the end of the year, it will not affect the shareholders' tax liability. All profits and losses sustained by an S-corporation are passed to the individual shareholders' tax returns, whether they received those distributions or not.

It is important to note that a distribution cannot be used to replace the paying of wages. The IRS requires shareholders that are part of the company's operations to draw a reasonable wage. If an S-corporation does not pay its shareholders or pays them an inadequate salary, it could be a red flag to the IRS and prompt an audit.

Some shareholders will pay less in taxes on their share of profits than they would on wages due to employment taxes. If the IRS determines a reasonable salary was not paid, they can subject all the profits earned to self-employment tax.

How to Distribute Net Profits Before Year's End for an S-Corp

One of the first steps in preparing the year-end net profits for an S-corporation is to determine a reasonable salary for shareholders who participate in operations based on the amount of work they perform. Though there are no set rules in determining this figure, using industry standards is usually sufficient.

When a salary is given to a shareholder, this money will be subject to employment and withholding tax, including employees' FICA taxes as well as federal tax and state taxes. These tax payments are deducted as a business expense when determining net profit.

The next step includes recording the distribution of profits to the shareholders before the end of the year. This will account for a reduction in shareholders' basis of investment in the company, but it cannot be deducted as a business expense. Distribution of profits is not subject to employment and withholding taxes.

The final step in the process is to use a Schedule K, which is part of IRS Form 1120S.This indicates each shareholder's portion of the profit. The corporation will not have to pay corporate taxes on the profits. Their portion of the profits will pass through to their personal tax return.

Equitable Distribution

Ownership in a corporation is based on holding shares of stock in the company. When creating ownership, a corporation can include multiple classes of stock, including both common and preferred stock. This allows a corporation to give some shareholders preferential treatment. An example of this special treatment is that a preferred stock owner might be entitled to receive their dividends before others with common stock.

In an S-corporation, the IRS restricts the classification of stock to one class, though it can have voting and nonvoting stock options. In this type of corporation, every shareholder has equal rights to the distribution of profits.

Percentage of Ownership

The profits and losses in an S-corporation are allocated to each of shareholder to claim on their personal tax returns based on the amount of ownership that shareholder has. To determine their percentage of ownership, divide the number of shares of a specific shareholder by the total number of shares.

Distributive Share

In a regular corporation, profits will be distributed to the shareholders as dividends, though they may or may not be in relation to the percentage the shareholder owns. A regular corporation can also decide whether to share all or some of the profits. They can distribute:

  • A flat amount to each shareholder
  • An amount per share
  • Dividends based on preferential treatment

If you need help with S-corporation profit retention, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.