S Corp Tax Question
February 9, 2017 at 12:03 pm #1474843
Real life question about s-corps. Assume a single shareholder s-corp, and net income is 100,000. This 100k does not take into account any self employment wages which obviously must be declared. If the shareholder declares 40,000 in self employment wages, how does this actually transfer to tax forms? 1. Does the sub s corp issue a w2 the to shareholder for 40k, and then the net income of the scorp becomes 60k. Or 2, does the scorp show 100k income (and issue no w2), and then the shareholder would declare 40k Self employment income to pay SE tax on.
Any explanations are appreciated.February 9, 2017 at 1:15 pm #1474873
If the shareholder pays himself $40,000 in wages, that will reduce the net income by $40,000 plus the employer portion of payroll taxes. Then that net income will flow through to the individual tax return. Or the shareholder could take out $40,000 as distributions and not pay payroll taxes, but then the $100,000 net income will be what flows through to the individual tax return.
This is my understanding of how it would work. Definitely want to hear other interpretations as well.February 9, 2017 at 2:25 pm #1474935
By the way you asked the question, I am assuming this single shareholder is also the only officer of the S-Corp and participate in day-to-day operation, and officer is an employee of a S-Corp, thus, he should be on payroll for a reasonable compensation and 940s series tax forms are to be filed. This is how it should be set up; clean and no mess. However, some people out there set up as single member S-corp but do nothing in term of payroll until the tax season when filing for 1120s. This is where the complication comes in. For correction, S-Corp still files 940s series tax forms, pay the should-be payroll tax on the 40k amount (in this case), only then the 60k will be on K1S and this will flow to personal tax return on line 17 of the 1040. Also, wait for IRS letter for penalty regarding to late 940s filing.
Disclaimer: I have a reasonable tax knowledge but not a tax expert. I am too confused regarding this issue myself. However, I've gone through the Schedule SE of the 1040. There is no place for income from K1S to go on there. Thus, you could not calculate self employment tax of 40k amount if you flow all 100k through. I'd like to hear from another tax expert regarding this matter.February 9, 2017 at 2:30 pm #1474944
The shareholder gets a W-2 just like any other employee. ForgottenOne addresses an important point that if you don't pay the salary on a periodic basis it will get more complicated when it comes to employment tax filings with 941(944) and 940. The payroll expense is deducted on the 1120S return just like any other business expense to arrive at net income. The net income flows through on the Schedule E to the individual's 1040 tax return and is reported as ordinary income, but is not subject to SE tax. This is different than a partnership, where all income is subject to SE tax. That is why in S-corp's, shareholders must take “reasonable compensation.” The officer salary will show up on line 7 of the 1120-S Corporate Tax Return.February 9, 2017 at 2:40 pm #1474954
I'm not experienced with the formality of handling this. Another accountant I know said the s corp would show 100k income to flow through to the sole shareholder and then the sole shareholder would show 40k on sched se, and the scorp would not issue a w2 to the sole shareholder. I wasn't sure if this was his way of handling it or the correct way of handling it.February 9, 2017 at 3:59 pm #1475026
I am tempting to do what he said too due to the fact that late filing 940s is almost a guaranteed late filing penalty. On top of that, taxpayer gets to deduct 1/2 of SE tax as an adjustment to income on the 1040. Also, SE tax is only 15.3% of the 92.35% of that 40k (see Schedule SE line 4). Its a win win win. However, this could lead to the path where many hours could be lost working to resolve an issue down the road with the IRS and the outcome might not even be favorable (depending upon the agent).February 9, 2017 at 6:41 pm #1475127
We actually have a post at our Evergreen Small Business blog that describes the specific steps you take to handle a $40K in shareholder-employee payroll situation. There are even examples of the completed 941 forms.
I assume this is okay to link to…February 10, 2017 at 1:24 pm #1475542
Good link seattlecpa, very informative. seems like the correct way when it's a scorp is to pay w2 wages to the shareholder/employee. Doesn't this mean though you don't ever have self employment tax as an s corp because the scorp is paying it's share of fica expense and withholding the employee’s share and filing the necessary 941’s, therefore, schedule SE would never be used in this scenario.February 15, 2017 at 4:36 pm #1478790
You don't have SE tax with an S corporation. I.e., if you make $100K in sole proprietorship, you basically pay SE tax on the $100K… it works out to about $12K once you make the Schedule SE adjustments.
With an S corporation, if you run the same $100K in profits business, but pay out $40K as shareholder-employee wages and then pay out the other remaining $60K as a distribution, corp and employee pay about $6K in combined Social Security and Medicare taxes.
That's the S corporation loophole. Here's a longer description of the loophole:February 16, 2017 at 12:14 pm #1479315
Thanks for the info SeattleCPA. Your referenced materials are very insightful, as I am trying to learn more about the subject.
In the seminars I’ve just taken very recently, some experts on reasonable compensation stated that if you take no distribution in a year, then you can get away with paying no wage in that year. However, in a subsequent year when you do take a distribution, the distribution should first account for reasonable compensation of the previous year and current year, and then any excess would be a dividend. So in essence, you can defer a wage, but not completely escape paying one by taking no distribution in one year.
I note this because my friend’s accountant was going to have my friend file sched SE for 2016 based on reasonable wages earned from his scorp, and he did not have him receive any w2 wages for 2016. In your experience, could this lead to a problem with the IRS (ultimately, he’s going to pay SE wages, but apparently not using the proper convention as it would be via Sched SE and not via 941/w2)? If it is a problem, and if that seminar info is correct, would a solution be to not take any distribution in 2016, and then catch up all wages for 2016 in 2017 via w2’s?February 17, 2017 at 9:12 am #1480027
I would say that all experts agree that if shareholder takes no distributions and also receives no other payments from corp that shareholder doesn't need to worry about IRS challenging corp on reasonable compensation issue. The reason is IRS needs payments to recategorize as wages.
I've got a blog post about this issue and similar issues here:
BTW, in real life, people do take zero money out of the S corp and then skip wages sometimes. But eventually shareholder needs to take distributions as you note. So this gambit is a short-term thing.
FWIW, I agree you could catch up the next year. Good idea.February 17, 2017 at 10:00 am #1480098
If the shareholder performs work for the s-corp he is required to receive “reasonable wages”. That means he would receive a W-2 just like any other employee and his wages are deducted from income. The earnings will flow to the shareholders and no SE taxes are paid on the earnings. If you are going to have the owner take distributions every year without paying him wages you will have to make an argument that he was zero participation in the s-corp. Definitely agree with @seattlecpa that if the owner takes doesn't take distributions then you wouldn't have to worry much about paying a “reasonable wage”.February 17, 2017 at 10:28 am #1480134
I'm not trying the be a dick but not all earnings from a partnership are subject to SE tax. Only earnings to general partners or any partner that materially participates in the partnership is subject to SE tax. If you have a limited partner, someone that is used for financing purposes, their earnings are not subject to SE tax. Again, I'm not trying to attack anyone by posting this.February 17, 2017 at 11:38 am #1480194
“BTW, in real life, people do take zero money out of the S corp and then skip wages sometimes. But eventually shareholder needs to take distributions as you note. So this gambit is a short-term thing.
FWIW, I agree you could catch up the next year. Good idea.”
thank you, this is very insightful. I am just wondering how do you “catch up” the next year? what form to fill out?February 17, 2017 at 1:55 pm #1480330
My understanding is as follows. Assume your reasonable wage is 40,000 per year. This year your s-corp makes no distribution. Therefore, you are not obligated to pay yourself any wage. Next year, you make a 100,000 distribution. You can’t just say that your wage is 40,000 and take a 60,000 distribution. Because you didn’t pay a wage last year, you will need to claim wages of 80,000 this year (40k for last year and 40k for this year), and the remaining 20,000 is a distribution. So your w2 should show 80k.
Seattle, do you have an opinion if you didn[‘t pay any w2 (because acctnt gave erroneous advices and to correct the issue you now tried d to claim wages via sched se, how that would go over with the IRS?February 17, 2017 at 5:44 pm #1489129
I think people are making this too complicated.
If the shareholder-employee in year 1 takes no wages and no distribution–and receives no other payments that IRS could and probably should reclassify as wages–that's fine. Period.
But the rule is that S corporations are supposed to pay reasonable compensation. And if that's not done, IRS can reclassify distributions and other payments to shareholder as wages.
I don't think there's any primary authority that provides a formula for catching up in year 2, year 3… Probably any rational approach would work. Probably anything that makes it look like S corp and shareholder are “shorting” the treasury is risky if you get examined.
The trick with S corp compensation is to use a reasonable compensation value and then structure the compensation so the shareholder gets non-taxable fringe benefits and pension contributions that in effect bump the shareholder-employee's compensation and that dial down the distributions subject to reclassification.
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