Many of our non-ROBS small business clients elect to file their business taxes as a subchapter S corporation. Under a regular C corporation (required in a ROBS arrangement), the business itself pays income taxes on net profits, and the business owner pays taxes on income from salary and dividends paid to the owner from the business. S corporation shareholders have a different angle of concern for their company’s annual performance: It has a direct impact on their own personal income taxes.
How It Works
Unlike a regular C corporation, an S corporation usually doesn’t pay federal income taxes itself. Instead, each shareholder is allocated a portion of the corporate income, loss, deductions, and credits on a special “K-1” tax form. The shareholder then must report the items listed on the K-1 on their personal tax return.
The K-1 allocations are based on stock ownership percentages. For example, if an S corporation has $100,000 of taxable business income for the year, a person who owns 75% of the stock in the corporation would be allocated 75% of that income, or $75,000.
This scheme can get complicated. Case in point: The K-1 may show more income than the shareholder actually received from the company during the year. That’s because the K-1 figure is based on the corporation’s actual taxable income — not on the distributions made to the shareholder. Taxable income for the business may include the value of inventory accruals, for example, tying up the profits in operating capital, not immediately available for cash payouts.
Here’s how this might impact a business owner: Janette starts a new corporation, electing subchapter S status. In the first year, Janette draws a $30,000 salary and receives no other distributions from the company. The company’s ordinary business income (after deducting her salary) is $10,000. Since Janette is the only shareholder, all the company’s $10,000 of income is allocated to her on her K-1. Janette must include both the $30,000 of salary and the $10,000 on her personal income tax return, even though all she actually received from the corporation was her salary.
This result seems harsh, but it’s not the end of the story. Special rules in the tax law prevent the same income from being taxed again. Essentially, Janette will be credited with already having paid taxes on the $10,000 so that any future distribution of the funds will not be taxable.
To determine whether non-dividend distributions are tax free, S corporation shareholders must keep track of their stock basis.* The computation generally starts with a shareholder’s initial capital contribution (or the stock’s cost if it was purchased) and changes from year to year as the shareholder is allocated corporate income, loss, etc. Non-dividend distributions that don’t exceed a shareholder’s stock basis are tax free.
Note that S corporation shareholders may be eligible to deduct up to 20% of their S corporation pass-through income. Eligibility depends on taxable income and other factors. S shareholders will want to consult their tax professional to see if they can take advantage of the deduction to lower the taxes on their business income. Baum CPA is the kind of tax professional that can help you with subchapter S elections, S corporation tax filings, and whatever business tax advice concerns you have. Click here to schedule an initial consultation with us today.
*Most distributions made from an S corporation are non-dividend distributions. Dividend distributions can occur if the company was previously a regular C corporation (or in other limited situations).
This blog and its authors provide this content strictly for informational purposes. No content herein should be misconstrued as financial advice. Everyone’s specific circumstances vary — Always consult with a qualified, licensed financial advisor, legal counsel, and tax professional before venturing into any investment or business activities.