All business owners face an interesting challenge: how to take profits out of the company and pay the least amount of taxes in the process. If you have an S corporation, there are basically two ways you can get money out of the company: by paying yourself a reasonable salary and by paying yourself distributions. The owner’s salary is subject to FICA and Medicare taxes while an income distribution is based on profits of the business and is not subject to FICA and Medicare taxes.
How it all flows
Below is an example of two years of a Sub S corporation that makes a profit in year one and breaks-even in year two.
ABC Corporation owned by John Smith makes a profit of $100,000 and John, the owner, (not the corporation) pays the taxes on the Profit. The Profit flows through to the Sub S owner who pays federal and state taxes on the profit.
The $100,000 Profit flows to the owner’s personal tax return and owner pays personal taxes of $20,000. Instead of writing a personal check, the owner elects to have the business write a check which is classified as an income distribution to the owner, leaving the business with $80,000 in the bank.
The owner elects at the end of year two to take a $70,000 income distribution.
He is not required to pay taxes since the business did not have a profit in year two. Taxes were paid in year one on the profit that was distributed in year two.
The important thing to remember is that the owner pays income taxes each year on the profits that flow to him/her. The income tax owed is calculated on the profit, not the amount of distribution.
- Year One – The owner took an income distribution of $20,000 to pay the taxes based on that year’s profit.
- Year Two – The owner took a distribution but no taxes were paid
The moral of the story is: You pay taxes when profits are incurred, not when the cash is distributed. To continue learning about this topic sign up for our Cash Flow Essentials workshop at www.ewhsba.com or for more information, contact EWH Small Business Accounting at 262-796-1040.