How is your business taxed?
Many business owners assume that if they have set up a corporation or an LLC that they can automatically be treated as an S-Corporation. Fake news! Any newly created legal entity (e.g. corporation, LLC) can be elected to be taxed as an S-Corporation, but it requires filing the request with the IRS. Failure to do so will default to the tax type normally associated with the type of entity. For a corporation the IRS could default to taxing you as a C-Corporation, for an LLC, the default is to be taxed as a partnership.
Types of taxes you pay?
As an entrepreneur, you are subject to more than just income taxes. The largest of these is Self Employed (SE) taxes or FICA. You pay SE taxes on all income generated from self-employment. For S-Corporations, the amount that is subject to SE taxes (technically FICA) is what you take out as a W-2 wage. Read our related blog post for a more in-depth look at Self Employment Tax and S-Corporations.
You pay income tax on your share of the income from the S-Corporation, regardless of how much you take out of the company (see special cases below). Amounts earned from an S-Corporation are not subject to the Net Investment Income tax (aka excess medicare tax) as long as the owner materially participates.
Two outlier cases to consider for S-Corporations. The first is when you convert a C-Corporation to an S-Corporation. Retained earnings made prior to the election to become an S-Corporation are subject to the effective corporate tax rate at the time of distribution. This doesn’t happen often but is worth noting.
The second case is when you take distributions (money or property) from the S-Corporation beyond your basis in the Corporation. These distributions are subject to capital gains tax. These distributions generally occur when you’ve taken a large loss for taxes that doesn’t reflect the cash flow of the company. This case happens more frequently, so be careful!
Most of the time, you generate the lowest taxes over time by electing to be taxed as an S-Corporation. Entity selection and tax planning are not static things, however. For instance, the Tax Cuts and Job Act (TCJA) lowered the corporate tax rate and made C-Corporations more attractive for some businesses. See our article about C-Corporation considerations to learn more.
If you’ve chosen an S-Corporation, it is best to set yourself on a W-2 wage that reflects the market value of the services provided. You can then take the rest of your earnings out of the S-Corporation as cash or property dividends.
Beware of taking NO wage as this is a huge red flag for the IRS, and make sure you avoid distributions that would run afoul of the two special cases mentioned above.