This discussion continues from the Making the S-Election and Incorporation topics.
Pass-Through Entity
Recall that once the S-Election is made, the corporation becomes a flow-through entity for tax purposes. This means that the taxes are paid at the individual level on the tax returns of the corporation’s owner(s). Additionally, the character of the income stays the same when it’s passed to the owners. Interest income to the corporation is treated as interest income to the owner. Capital gain to the corporation is treated as capital gain to the owner, as so forth.
Corporate Tax Return
The S-Corporation files a tax return and reports the business’ net income, assets, and some other important tax-related items. The corporation’s net income is then assigned, or “passed out”, to the owner(s) based on their pro rata share of ownership. The output of the corporate tax return is called Schedule K-1 and one is prepared for each owner. The K-1 is reported to the IRS with the owner’s name, address, SSN, and share of tax-related items. As a result, the IRS will expect for this income to be appropriately reported to the owner’s personal tax returns.
Capital Distributions
A healthy corporation may accumulate cash from many months or years of positive net income. Since net income has already been paid by the owner(s) on personal tax returns, this cash can be considered “post-tax” dollars. Whenever deemed appropriate, the shareholder(s) can distribute this cash. Formally, it’s called a “capital distribution” or “shareholder dividend”. Informally, it’s sometimes called a “cash draw”. Regardless, these distributions must be pro rata according to stock ownership.
Equity & Basis
The sum of all corporate assets (e.g. cash & equipment) minus the sum of a corporate liabilities (e.g. credit card & loan balances) equals the corporation’s equity. The equity, also called “basis” represents the shareholder’s investment into the corporation. Essentially, a shareholder’s basis in the corporation is how much post-tax dollars they have invested. The concept of “cash basis” or “tax basis” factors into whether or not a cash distribution can or should be taken. Net income increases basis, net loss decreases basis. Capital contributions increase basis, and capital distributions decrease basis. When net income is earned by the corporation, typically about that amount of income can be withdrawn from the corporation by the shareholders as a distribution.
Taxation of Cash Distributions
The net income of an S-Corporation is always taxed and assigned to the shareholder(s). The income is taxed whether or not the shareholder touches the cash. As a result, the shareholder(s) will be taxed on their pro rata share of corporate income each year, whether or not they receive a capital distribution. Therefore, shareholder taxation of these distributions should not be a guiding factor as to whether or not the funds should be withdrawn.
Example
Consider an S-Corporation with 3 owners with ownership percentages as shown: Owner A (60%), Owner B (30%), and Owner C (10%). At the end of Year 1, the corporation earns $100,000 of net income and reports such on the corporate tax return. According to their ownership, the corporate tax return provides three Schedules K-1, with net income “passed out” to each owner as shown: Owner A ($60,000 net income), Owner B ($30,000 net income), and Owner C ($10,000 net income). The corporation wants to invest the cash back into operations, so none of the cash is distributed to the shareholders. Regardless, each owner will be responsible for paying income taxes on their share of the corporation’s income. In Year 2, the corporation reports $200,000 of net income. According to their ownership, the corporate tax return provides three Schedules K-1, with net income “passed out” to each owner as shown: Owner A ($120,000 net income), Owner B ($60,000 net income), and Owner C ($20,000 net income). Now with positive cash flow, a few months into Year 3, the shareholders agree to distribute as much cash as possible to themselves as follows: Owner A ($180,000 cash received), Owner B ($90,000 cash received), and Owner C ($30,000 cash received). These cash distributions are not taxed to the shareholders in Year 3 because taxes were effectively already paid by the shareholders in Years 1 & 2.
Exception: CA Corp Tax
S-Corporations aren’t taxed at the corporate level, except in one situation. The privilege to operate as a corporation in California comes with an annual payment of tax to Franchise Tax Board. As of the time of this writing, the annual tax is the greater of $800 per year, or 1.5% of the corporation’s net income.
Dave Sholer, CPA, MBA works exclusively with dentists in California, offering full-service accounting & tax solutions for dental practices of all sizes.
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