Are Distributions Taxable?

The owners of S corporations (and LLCs taxed as S corporations) have options to take money out of the business. The allocation of the money as wages or distributions will affect the way that it is taxed and should be carefully planned to maximize tax savings.

An S corp is taxed as a pass-through entity. This means it does not pay federal taxes and the shareholders (owners) report the earnings on their individual income tax returns. The shareholders are often working in the company and are considered as employees, as well as being investors. The shareholders can be paid through wages and distributions.

Wages are subject to federal withholding and FICA taxes, and the business must pay the equal amount of taxes out of its own funds to the IRS. At the end of the year, the business issues a form W-2 to the employees/shareholders and the wages must be included on their personal income tax returns.

Distributions to shareholders are not taxed the same way. They are considered to be a return on the shareholder’s investment in the company and are not compensation for their work. The distributions are not subject to FICA tax, nor self-employment tax. The distributions are included in the shareholder’s personal tax return.

Therefore, apportioning the amount of wages and distributions could be beneficial for tax savings for the shareholder/employee and the company. The company cannot neglect to pay the employee a reasonable salary for services rendered. The IRS looks carefully at the salaries paid to employee/shareholders, so it is important to not set a salary that is too low or unrealistic for your industry.

Make sure you are paying yourself in a way that gives you the biggest tax savings. Consult us at H&H CPAs, we are happy to help you with your tax planning for the best results.