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Q & A: Getting Cash Out Of An S Corporation

Q: I am considering converting my business from a sole proprietorship to an S corporation. I am the only owner, and I heard that I could save money in payroll and self-employment taxes. Is there any potential negative impact I should be aware of before making the switch?

A: That’s a frequently asked question, and one that should be carefully analyzed before taking action. Business owners have various options when determining the tax status of their business. Sole proprietorships, partnerships and S corporations make up a large majority of businesses today.

As a sole proprietor, your net income is subject to ordinary income tax and self-employment tax. A partner in a partnership is also subject to ordinary income tax and self-employment taxes on the income passed through from the partnership. A shareholder in an S corporation is treated differently. Net income passed through from the S corporation is subject to ordinary income tax, but not to self-employment tax. A shareholder is, however, required to pay himself a ‘reasonable’ wage, which ultimately is subject to employment taxes.

An important factor to consider is how you will withdraw money from the business. If selected for audit by the Internal Revenue Service (IRS), this is one of the areas typically examined. Generally, a shareholder can 1) be paid compensation, 2) receive a distribution, or 3) take a loan from the business. An IRS agent will analyze these payments to determine if they have been properly characterized.

Compensation.  A shareholder in an S corporation is required to be paid a reasonable wage. There are multiple factors that determine what a reasonable wage should be. Withholdings are required to be made from these wages for federal, state and sometimes local taxes, as well as Social Security and Medicare taxes. The S corporation is also responsible for the employer portion of Social Security, Medicare and federal and state unemployment taxes.

For example, a shareholder paid $100,000 as a wage during the year would have federal, state and possibly local income tax withheld, as well as Social Security and Medicare of $6,200 and $1,450, respectively. The S corporation would be responsible to pay the same amount of Social Security and Medicare tax for the employer’s portion, along with an additional $400 or so in federal and state unemployment taxes. The total amount of employment taxes, not including income withholdings, would be approximately $15,700.

Distributions. When a shareholder receives a distribution from a corporation, assuming he has enough basis in the business to do so, it is a tax-free return of equity. Generally, a business owner may wish to keep sufficient cash in the business during the startup phase to maintain a comfortable cash flow. Once the owner is more in tune with the business cycle and cash flow, he may wish to pull some of the cash out as a distribution. Since the owner is taxed based on the net income of the business whether he takes money out or leaves it in the business, the distribution would be tax-free in this scenario.

Using our example above, if the owner had taken a distribution of $100,000 instead of paying it as a wage, he would have saved $15,700 in employment taxes. This may seem like an ideal choice, and many shareholders have chosen this form of payment. Unfortunately, they often fail to consider the reasonable compensation requirement.

Loans. Shareholders may lend themselves money from the company and pay it back. The lending of the money is not a taxable transaction assuming the loan is a bona fide loan. The business should make sure that the loan is an enforceable obligation to pay a fixed or determinable sum of money, and is properly documented. A large receivable on the books as a result of recent payments to a shareholder who has little or no compensation could be a huge red flag in the audit process.

In recent years, payments to S corporation shareholders have been a hotly contested issue. The IRS has argued that shareholders received compensation disguised as a loan or distribution. Audits have resulted in payments to shareholders being reclassified as compensation, which would then be subject to employment taxes being imposed on both the shareholder and the company, as well as triggering penalties and interest. Shareholders have disagreed with the proposed adjustment and fought it in tax court. Unfortunately, there have been many instances in which the taxpayer lost the appeal. The tax courts evaluate a number of factors to ultimately decide whether the reallocation is justified.

Below are some things you can do to shift the odds in your favor.

As a shareholder of an S corporation, you should decide early in the process how you will pay yourself. It is very important to document this in advance. One piece of documentation that is frequently overlooked in a small business is the company’s corporate minutes. During an audit, the IRS will request to examine the corporate minutes. Auditors are trained to review the minutes to see if there has been any mention of items such as payments to shareholders.

You should also evaluate your wages based on the number of hours you work in the company and the duties performed. Often in tax court cases, comparisons are made to what employees of similar companies have been paid. The history of compensation paid to a shareholder has also been scrutinized. For example, if a shareholder were to pay himself $150,000 one year and no compensation the next year, there should be a valid reason supporting the change, such as the company’s financial condition has worsened. If the shareholder of an S corporation in a services industry is responsible for a majority of the sales, but makes far less compensation than any other sales agent in the company, then a good explanation is necessary.

It is not a crime to take a distribution or loan from your S corporation; it is just wise if you are going to take cash out of the company via one of these forms to document it properly. Again, the corporate minute book would be an excellent place to document a distribution or loan to be made. If this pattern is followed over a number of years, then the S corporation has a history to provide to an IRS auditor in the unfortunate event of an audit.

Business owners can save time, money, and significant headaches by considering the implications of how they choose to get cash out of the company prior to actually making the payments.

One response to “Q & A: Getting Cash Out Of An S Corporation”

  1. paul lichtefeld sr. says:

    Bill Dermody is our account. Please send this to him.

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