The Internal Revenue Service (IRS) defines an S Corporation as a corporation that decides to let its income -- as well as losses and deductions -- pass through to its shareholders, who must report the income on their personal income tax returns. Pass-through taxation lets the S Corporation avoid double taxation on its income, according to the IRS. If you are an S Corporation shareholder, you may withdraw corporation revenue in four ways; some minimize taxation.
Distributions in the S Corporation
S Corporation shareholders may take a revenue distribution from the corporation that's based on the number of shares they own. According to the IRS, revenue distributions or dividends are not subject to certain taxes. While shareholders must still pay federal and state income taxes on distributions, they don't have to pay FICA or Medicare as long as the revenue earned is classified as a distribution and not wages. Top earners are federally taxed at a rate of 35 percent; state income taxes vary.
Unlike distributions or dividends, wages paid from an S corporation's revenue are subject to FICA and Medicare taxes in addition to federal and state income taxes. However, if an S Corporation opts to pay wages instead of or in addition to distributions, the corporation can fund a pension, which is calculated as a portion of your wage and may save on income taxes down the road. Remember that company-sponsored retirement plans grow assets tax free, and allow plan owners to take distributions after age 59 1/2, when income is presumably lower, reducing the tax burden.
If a shareholder loans money to an S Corporation, then it's possible to get repayment from revenue with interest on a tax-free basis. Loans repaid to shareholders with interest prove that the transaction is "at arm's length," and although the interest expense is taxable income to the shareholder, it's a deductible expense for the corporation. According to QBalance.com, "good business practice dictates" that shareholders should get loan agreements in writing, otherwise the tax consequences may be severe.
If a shareholder funds an S Corporation and expects reimbursement, then the reimbursement should come directly from the corporation. If you're a shareholder and you need a distribution to pay a bill -- a credit card bill, for example -- be sure to pay personal charges through your own accounts and business charges through the business accounts. This will avoid IRS scrutiny, and will save time, money and headaches down the road.
The IRS expects S Corporation owners to reasonably compensate employees, and failure to follow guidelines may result in a tax nightmare for shareholders. The worse case scenario occurs when revenue distributions are reclassified as wages by the IRS, resulting in extra taxes and penalties. To avoid this problem, speak to tax advisor before distributing revenue through distributions, wages, loan repayments or reimbursements. QBalance.com recommends selecting a program and sticking to it.