Similar to an LLC, an S-Corp can be composed of a single shareholder or multiple shareholders. However, being a corporation, the S-Corp must file Form 1120S (U.S. Income Tax Return for an S Corporation) and issue K1’s even if it has only one shareholder. S-Corp shareholders have several unique restrictions. For example, shareholders must be an individual and cannot be another entity like another corporation or an LLC. The individual to be a U.S. citizen or a resident alien and the S-Corp cannot exceed 100 shareholders.
An S-Corp, however, is still a pass-through entity and will submit an informational return to the IRS known as Form 1120S. Each of the shareholders will be issued a K1. The K1 for each owner will designate how the owner’s share of income, deductions, and credits are allocated for tax purposes on their personal 1040 tax return. To be clear, while an individual is responsible for paying the taxes for a profitable business, the business does not have to physically write the owner a distribution check for the full amount of the company’s profits. In fact, it is advisable that some of the profits be retained by the business to cover future expenses and provide capital for growth.
For my shareholders, I would generally issue a distribution to cover the shareholder’s tax obligations and retain the rest to reinvest in the business. When you are just an investor in an S-Corp, ostensibly you do not work for the business and you do not participate in its management as an officer. You are therefore considered limited in your liability and your income from the business based on your ownership share of the business is usually considered passive income. Passive income, as you will recall, is not subject to FICA or Medicare taxes. Therefore, your income will be subject to federal and state income taxes based on your marginal tax rate only.
NOTE: To be 100% accurate, there are some exceptions where your CPA might designate your income as ordinary income yet not subject the income to self-employment tax since the income is in a corporation. This is especially useful if the company has a loss so it will not suspend in the year of occurrence. However, this situation is beyond the scope of this discussion and is generally a rare occurrence.
Throughout the year, the business may make periodic distributions to compensate you as a shareholder. The business does not withhold taxes on distributions. At tax year end, the S-Corp would file its Form 1120S showing a net profit after deductions. The S-Corp would issue you a K1 showing your share of the S-Corps income, deductions, and credits. As a shareholder, you will use the K1 from the S-Corp to populate your Schedule E (supplemental income and loss).
When it comes to taxable income, the onus is on you to estimate the taxable income you will receive and then make quarterly deposits to the IRS using Form 1040-ES to cover the anticipated annual tax liabilities. The same is true for your estimated state taxes. To avoid IRS penalties, your tax estimates should add up to at least 90% of your estimated tax liability.
Are you paying your S-Corp shareholders properly?
I would like to acknowledge Karen Absher of KSA Financial & Tax Services for her gracious assistance as a reviewer to make sure that the tax issues conveyed in this post were an accurate representation of US tax law.
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