An S corporation is a "pass through" entity, and is taxed under the IRS code, Subchapter S. The corporation does not pay business income tax, and is taxed instead on the shareholders' personal tax returns. An S Corporation is usually a small corporation with a limited number of shareholders who also might serve as officers and directors for the corporation. For tax purposes, S Corporations must distinguish salaries from shareholder distributions, because the same person may receive both. Salaries are a business expense that must be reasonable in size, and the corporation will withhold taxes on the income. Conversely, shareholder distributions are a reflection of the profit made by the corporation, paid out after all other expenses.
Salaries for Shareholders and Directors
Shareholders may work for the company and may receive compensation as an employee. The shareholders also may decide to pay the directors a compensation, which would be considered salary. In instances in which the director is also a shareholder, his compensation as a director would come out of the company's gross income as a business expense. Because shareholder distributions are determined by the profit of the company after all business expenses are paid, employee or board income is paid out before any shareholders receive profit distributions.
The IRS requires shareholders who work for the corporation in any capacity to be paid a reasonable salary. Although the IRS does not have specific guidelines for salaries, it does list a number of factors that should be considered when determining reasonable compensation. These factors include training and experience, the job responsibilities, time devoted to the business, payments to non-shareholder employees, and what similar businesses pay for comparable services.
Pass Through Taxation
An S corporation is a pass through entity, which means that the corporation has elected to pass corporate income, losses, deductions and credit through to their shareholders for tax purposes. The shareholders report the flow through income on their personal tax returns, and are taxed at individual income tax rates. As a result, an S corporation avoids double taxation, meaning that the business does not pay corporate tax before the income goes to the shareholders. However, S corporations may still be responsible for state taxes, as well as federal taxes on certain built-in gains and on passive income.
Salary vs. Distribution
When an S corporation pays compensation to a director, or to any employee, this is treated as an expense for the corporation. Further, the corporation must comply with IRS regulations pertaining to wages. Generally, the corporation must withhold income tax, as well as part of social security and medicare taxes. Employers are also responsible for paying federal unemployment tax. Compensation and tax payments come out of the corporation's gross income. In contrast, shareholder distributions usually occur at the end of the year. After all expenses are paid, each shareholder receives a proportionate share of the profit or loss. A shareholder who is also a director, would receive her full distribution on top of any compensation she received for services rendered.