They pay taxes the following ways:
- Since the S-Corp tax return is an informational return, which means no tax is paid alongside it, the owner/shareholder will get issued a Scheduke K-1 which would contain his share of income and loss from the S-Corp business, the profits and losses get distributed amongst it shareholder/owner or owners and they are the ones who are liable to pay tax on it.
- Schedule K-1 for each partner reflects his/her individual share of profits on which he owes taxes.
- The owner is required to attach that Sch K-1 alongside his individual form 1040 on which he pays the income tax( depending on his federal tax bracket whether its 24% or 27% or higher)
- In case when the S-Corp sells an asset such as real estate for a gain and it is subject to Long Term Capital Gains Treatment, that entry would be reflected both on the S-Corp’s tax return and also as capital gains on the shareholder/owner’s Sch K-1 as well.
- Profits: I’ve already talked about how profits gets distributed and reported.
- Losses: The S-Corp owner has an advantage over a C-Corp owner. The S-Corp owner can use losses to offset against his other income that can help him reduce his overall taxable income. (I mentioned of it in my previous newsletter).
- Payroll Taxes: A S-Corp owner is required to take a reasonable amount of pay each month. Which means he would now have to run payroll for himself and eventually pay payroll taxes (Social security+ Medicare taxes) to the Govt.
Bottom line: S-Corps are pass through entities, they never pay taxes. Its the shareholder/owner or owners who are liable to pay taxes on the business’ profits. Paying payroll taxes is still better than paying self-employment taxes( @15.3%) , might as well incorporate quickly.
S-Corp Owners- Beware!
Under IRS Scrutiny are Owner’s Salaries
In order to avoid paying employment taxes( also known as payroll taxes, I just talked about them above), some S-Corp owners take less salaries and more dividends. If you get audited, and the IRS finds out that those dividends were actually salaries, you would have to pay back dated payroll taxes plus penalties plus interest on all those amounts.
Bottom line: Take a 70-30 split where 70% is wages/salaries and 30% is dividends to avoid any red flags.