Lol, that's a good one.
The pertinent issue is whether he paid himself "reasonable compensation" in the form of salary. Anything he paid himself as a dividend would avoid medicare tax. Being a republican, I'm surprised you know so little about this issue.
qbalance.com
S Corp owners may withdraw earnings from the business as:
distributions from S corporation earnings (similar to dividends of a C corporation)
wages
repayment of loans
reimbursed expenses
Distributions from an S Corp are not subject to FICA and Medicare taxes. This translates to a potential savings of up to 15.3%. Withdrawals in the form of distributions (dividends) are still subject to federal taxes at the ordinary income tax rates- top tax bracket 35% (Recently tax changes provide for a tax break on C corporations dividends -top rate of 15% - but this does not apply to S corporation distributions.)
Wages are subject to FICA and Medicare payroll taxes (15.3%) and are subject to ordinary income tax rates. But the bonus to paying wages opens up the opportunity to fund a pension that will save federal taxes at the ordinary income rates (top tax rate 35%). Pension rules generally permit funding a pension as a percentage of your wage ( Distributions are not wages and therefore are not counted in the pension contribution calculation). The tax savings will continue when money is contributed to a pension because the pension will grow tax free until retirement (compounding the growth of the investment).
Loans should be repaid with reasonable interest which is subject to income tax but (interest) is deductible as a business expense. So, as an average taxpayer you will have not have an increase in taxes as a result of the interest paid, but this is a bit of bureaucracy which we recommend you follow. Paying interest will provide support that the loan is arms length and not a disguised capital contribution. Good business practice dictates that when you lend money to your corporation you must get a formal Note (in writing). If you want the loan repaid without tax consequence, you will follow these guidelines. Most business owners will fund the start-up checking account with money from their personal accounts. A portion of these funds should be allocated on the balance sheet as a capital contribution (payment for the purchase of company stock). The amount allocated to Capital should be a reasonable value ( for example $1000 for a service business, more for a business that requires significant purchases of inventory or machinery). The remainder invested may be repaid as a loan provided there is a note drawn and interest payments are made at regular intervals at a reasonable rate of interest according to the note document. Lack of interest payments would infer the debt is contingent upon corporate profits, which is considered a second class of stock. A second class of stock will permit the IRS to discard the S election and submit your company to C corporation taxes (double taxation.)
Expenses paid from an owners pocket can be repaid to the S Corp owner with a company check. Just a side note - try to pay the vendor/ payee directly with company funds. There could be more scrutiny with reimbursed expenses than payments directly from the business account . For charge cards used for both personal and business purposes, send 2 checks, one from your personal account to pay personal charges and one from the business account to pay business expenses
Wages and Distributions compared
Strategy 1: Lets take the example of a new attorney who for the first year of business will earn after expenses
(but before wages) $87,000 (the 2003 FICA limit). For every dollar his wage falls below the social security limit he and his company saves a combined 15.3 cents in payroll taxes. Lets assume that from these S Corporation earnings of $87,000 a wage of $50,000 per year is paid and the remainder of $37,000 is paid as a "distribution". The payroll tax savings ( $37,000 -not subject to social security- x 15.3% ) would save $5,600 per year.
The attorney starts a profit sharing pension plan in year one and contributes the maximum (25% of wages with an upper limit of $40,000 for 2003). With a $50,000 wage his pension contribution is limited to $12,500 ($50,000 x 25%).. This pension expense will save as much as $2500 (depending upon his personal tax bracket) in federal income taxes.
With an allocation of $50,000 wage and $37000 distributions and $12,500 pension contribution he has saved $8,100 in federal income taxes.
Strategy 2: All earnings paid as wages
$87,000 paid as wages. While there is no social security tax savings, the attorney can contribute $21,750 (25% x 87,000) as a pension contribution saving as much as (depending on his tax bracket) $4,700 on federal income taxes .
Result of selecting Strategy 1 over Strategy 2: An increased tax savings of $3,400.
Benefits of strategy 2:
The additional pension contribution ($9,250) will grow "tax free" until retirement, preserving wealth and compounding earnings.
Contributions are made toward social security benefits.
( "distributions" - s corp dividends - are not taxed on Fica/Medicare therefore not counted towards your retirement benefit. To find out how withdrawing earnings on distributions rather than as of wages request a free social security statement. Request several statements. Complete each request with a different projected wage. For a quick calculation can use the online calculators and input various scenarios to see how your benefits can be affected by your decisions.
It is important to consult with your CPA to determine the right balance between wage and "distributions" and to revisit this decision annually.
Stick to the program!
Once you have established the most tax effective strategy, follow it. Click on this link: The IRS loves to collect payroll taxes and will seek out an S Corporation that pays NO wages to officers of the corporation or pays unreasonably small wages. Why? To collect additional payroll taxes. |
