How to Pay Yourself and the IRS as an S-Corp Owner
Two key questions for the owner of an S-Corporation are how to pay themselves, and how to pay the taxes owed to the IRS.
An S-Corp is a pass-through entity. This means the S-Corp files a tax return on Form 1120S, but it doesn’t pay any income tax. Instead, the owners receive a K1 schedule showing their allocation of profits, and pay the income tax on their personal tax return Form 1040. The tax rate varies depending on the amount of S-Corp profits, as well as the owner’s income and deductions from other activities.
How to pay the S-Corp Owner?
As an S-Corp owner, you will typically pay yourself via wages and cash distributions. The IRS requires an S-Corp owner who performs more than minor services for the company to pay themself a reasonable compensation in wages. After paying wages, the S-Corp owner can take a cash distribution.
It’s important not to get confused between profits and cash distributions. Profits are taxed in the year earned, whereas cash distributions of those profits are tax free. Here’s an example to illustrate:
John is an S-Corp owner and his business makes a profit of $500,000 before subtracting his wages. John pays himself $100,000 in wages. The business can deduct his wages as an expense, so the net profit after owner’s wages is $400,000. John’s wages of $100,000 get reported on a W2 wage statement, and the net profit of $400,000 gets reported on a K1 schedule, representing a total of $500,000 taxable income on his personal tax return Form 1040.
Now, if John takes a cash distribution of $200,000 it will not affect his taxes, and he still reports the same total of $500,000 taxable income on his personal tax return.
Note that if instead John paid himself $150,000 in wages, he would still report the same $500,000 taxable income on his personal tax return, just a different split with $150,000 reported on a W2 and $350,000 on the K1.
The business owner has the discretion to reinvest profits in the business, or take a distribution this year, or a later year. The IRS will tax those profits in the year earned, not the year distributed.
There are other factors when planning wages and distributions that may warrant discussion with your tax professional. For example, wages are subject to payroll taxes and can influence social security benefits. S-Corp distributions need to be made to every shareholder in proportion to their ownership. In some circumstances, distributions may be subject to capital gains tax if they exceed the owner’s tax basis. Also, the business owner may want to receive at least enough cash from wages and distributions in order to pay his taxes.
How to pay the IRS?
Taxes are due to the IRS in quarterly installments during the year income is earned. Since the final taxes owed will not be known with certainty until the year has ended and the tax return has been prepared, estimated payments are made during the year.
There are two methods to make federal income tax estimated payments to the IRS and typically the S-Corp owner will utilize both methods. The first method is through federal tax withholding on wages, which will be deducted via payroll and sent directly to the IRS. This amount of taxes paid will be shown on the year-end W2 wage statement. The second method is by direct payment to the IRS, either using electronic bank draft via the EFTPS system or the IRS website direct pay function, or by mailing the IRS a check with a payment coupon.
Let’s go back to our earlier example, and assume that John’s actual tax rate when he files his final return is 20%, hence he owes $100,000 in taxes for the year on the $500,000 income. His payroll was configured to deduct $5,000 from his monthly paychecks totaling $60,000 for the year in federal tax withholding. John paid $12,000 a quarter in estimated payments using IRS direct pay, totaling $48,000 for the year. Since John made total estimated payments of $108,000 during the year, he will receive a refund of $8,000 when he files his tax return at year-end.
Note that in this example, John could choose to deduct his entire paycheck and send the $100,000 in federal wage withholding to the IRS and this would be sufficient to cover his entire tax liability for the year without the need for any quarterly direct pay estimates. At the end of the day, it does not really matter how the taxes are paid, only that they are paid timely and in sufficient amounts to avoid late payment interest and penalties.
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