Your LLC is up and running. You’ve figured out the benefits to being taxed as an S-corporation and have placed yourself on the payroll. Not to be unreasonable, you took steps to make sure your salary would be acceptable to the IRS should they choose to review it.
Now that your company is profitable, how do you get that profit into your pocket without creating tax headaches?
Here are four facts you need to know about distributions from an S-corporation.
1. A distribution does not impact the profit and loss
Setting up a business requires a basic knowledge of accounting. At the very minimum, a regular review of the profit and loss and balance sheet are essential to see how transactions are flowing through your business. A profit and loss, also referred to as an income statement, shows the income and expenses of the business that ultimately impact your tax situation.
Unlike an income or expense transaction, a distribution is an equity transaction, meaning it is a transfer of equity (ownership) when it is removed from the company. The payment is simply a transfer of equity from the ownership in a company as a cash payment to the owner.
In publicly traded companies these are referred to as dividends. Chances are good you receive a dividend from a public company on a regular timeline, usually quarterly. These are morale enhancing payments to owners of companies to remind them they own the company. They are paid out of profits of the company to the owners on record as a benefit to being an owner.
Simply owning shares of a publicly traded company does not make you an employee or lender to the corporation so these payments are not expenses to the company. You are an owner therefore you have an equity position in the companies and these dividends are cash transfers of your equity to your brokerage account.
In the same way, your S-corporation makes payments from the owner’s equity to the owner. Unlike a publicly traded company, these are not called “dividends” rather “distributions.” And because they are paid out of equity, don’t expect to see them reflected on the income statement.
A distribution will not reduce your taxable income.
2. Like a dividend, only better
Like a publicly traded company, your company should reward you for being an owner. Your company needs to first be profitable and have employees (including you), before you take a distribution.
Unlike a dividend though, a distribution is not taxable to you*. Much of the headlines of dividends in the news tout a special tax rate for qualified dividends. However, a distribution is not a qualified dividend so this doesn’t apply to distributions from your S-corporation.
An S-corporation is considered a flow-through entity. As it sounds, flow through entity does not pay taxes at the entity level. Your S-corporation impacts your taxes as profitability of the company flows into your personal tax return. You will pay taxes on the income from your S-corporation as it flows through, regardless of distributions.
Taking a distribution doesn’t impact your taxes because it doesn’t impact profitability. If your company has a $100k profit, you personally will pay taxes on that profit regardless of distributions. Removing money from your company makes no impact on the profitability and there is no tax for these payment to the owner.
3. Distributions must be proportionate
When you elected to be taxed as an S-corporation, you submitted to the laws governing corporations. One of the most important rules regarding corporations is that the distributions must be proportionate to the ownership of the company.
This makes things really clean. If you own 50% of a corporation for a year, by law you need to receive 50% of the distributions for the entire year. If you don’t, it voids the S-corporation election and defaults to a C corporation. (And C corporations are required to pay income taxes.)
That seems straightforward, right?
Here the challenging part; earnings of an S-corporation are calculated on a per share, per day basis and the distributions need to be proportionately allocated. That means when the ownership changes during the year, you need to allocate distributions based on the number of days you own the stock and percentage of the company you own.
If you’re a 18% owner for 200 days and then you purchase another 15% for the remaining 165 days, that all needs to be calculated to determine the overall percentage of ownership for the year. Your distribution needs to be proportionate to the annual ownership. Take your time and get this one right, the chances for error are high here.
4. Distributions are not subject to payroll taxes
Of the most important aspects for distributions, there are no payroll taxes due on the distribution. This means the 15.3% payroll taxes that is FICA (a tax few understand) is not imposed on a distribution.
Dollar for dollar, if an owner pays themselves a bonus versus a distribution, they are paying an additional 15.3% in taxes on the bonus. For tax purposes, a distribution is far superior to a bonus. Assuming the owner is paying themselves reasonable compensation, avoid a bonus and use the distribution to put money into the hands of the owner without all the payroll taxes.
Understanding distributions will enable you to further understand your tax situation and factors influencing your business. Distributions are an important motivating factor for an owner. A well-run company should be paying the owner regularly and distributions are the preferred method to do that.
*Assuming your S-corporation is not subject to basis limitations. See What is Basis?