Q&A: Are Your S-Corporation Distributions Taxed?
Q: I own an S-corporation. Am I taxed when I distribute money to myself?
This is a really common question. If you send money to yourself from the practice, does it get taxed again?
Do you save taxes by keeping it in your business bank account?
It’s common for practice owners to have business entities taxed as S-corporations. Even independent contractor ODs – right or wrong – are often advised for tax reasons to form an LLC and be taxed as an S-corp.
But S-corps can be confusing. I’ve seen this confusion lead to decisions that aren’t always favorable, like keeping too much cash sitting in the practice.
So, let’s bring some clarity to this question with S-corp tax basics!
Q: How do you create an S-corporation?
The S-corporation isn’t actually a legal entity you can form or create with your state. It’s a way your business chooses to be taxed.
You create an LLC or a corporation as your legal entity, then you decide whether to be taxed as an S-corporation (using Form 2553) if it makes sense to do so.
Q: On a High Level – How do S-Corporations get taxed?
How do S-Corporations work from a tax perspective? S-corps are “pass-through” businesses.
Meaning, the S-Corp doesn’t pay its own tax, even though it files its own tax return (1120-S). All the taxable profit of the business will “pass through” and land on your personal tax return.
When you own a business taxed as an S-corp, you get income from the business in two ways:
- A required “reasonable” salary, and
- The profit of the business
Paying yourself a “reasonable” salary for the work you do in the practice is a requirement. The first dollars you pay yourself out of the practice have to meet this requirement.
Your salary is taxed just like working as an employee elsewhere. Your practice will issue you a W2, and you’ll find this income on the Line 1 “Wages” spot on your federal tax return.
After that, assuming your practice can support it, you can also distribute profit to yourself out of the practice. Essentially, transfer funds out of the business bank account to your personal account or write yourself a check and account for it correctly in your bookkeeping. This is the S-corp equivalent of a dividend.
Business profit is also taxed in the year it’s earned – regardless of whether you keep those dollars in your business bank account or distribute them. After you file the 1120-S return for your business in March, you’ll receive a K-1 with your share profit or loss that you’ll use to file your personal tax return.
You’ll find this on Line 8 under “other income from Schedule 1”, where your Schedule E income appears.
Q: Ok, but what about those distributions?
What does this mean for distributions?
They generally don’t trigger additional income tax. That profit has already been taxed (or will be this year) whether it stays in your business bank account or not.
Each year, you can decide whether to retain earnings in the business or distribute it to shareholders. Consider it a return of (already taxed) profit to you, the shareholder.**
So, whether or not to distribute money out of your practice should be determined by:
- Have you set aside enough for taxes?
- Are required debt payments made?
- What are the cash / reinvestment needs of your practice?
- Cash needs of your household – how do you plan to build net worth outside of the practice?
- Are there cost basis issues if you distribute?**
Some confusion may come from the fact that C-corporations (think any publicly traded stock) issue dividends that are taxable income. If you own any stocks, stock mutual funds, or ETFs in a non-retirement investment account, you’ll see those dividends on your tax return.
But simply sending money out of your S-corporation bank account to your household generally does not trigger additional income tax. There’s no need to keep more cash in your practice than is reasonable or necessary for the business.
Hopefully this helps bring some clarity around how your business works.
As always, work closely with your own professionals. Once a business entity is involved in your life, you’ve moved into an area where good tax, legal, bookkeeping, and financial advice is well worth the investments.
Have a prosperous May!
**P.S. Distributions do impact something called the “cost basis” of your S-corp. That’s sort of an ongoing ledger of all the value in your business that’s already been taxed, and won’t be taxed again. In certain situations when your distributions are more than your cost basis, it can trigger some weird tax stuff like capital gains tax. Losses in the early years or a lot of accelerated depreciation can lead to those issues.
That’s a bit more than this newsletter can handle, so, keep in touch with your tax and financial pros when planning distributions.
If you’d like a question answered in a future newsletter, let us know! Or simply post it in the ODs on Facebook group, and we’ll work to answer as best we can.