Remember, payroll taxes (Social Security and Medicare taxes) are the same as self-employment taxes. But they also include unemployment taxes, state disability insurance (such as California’s state disability insurance- CASDI) and other odd-duck local taxes. We discussed this in previous sections. As an S Corp shareholder, you are taking money out of the business in four ways-
Let’s talk about everything except a reasonable salary for your S corporation first. When you write a check to yourself or transfer money from your business checking account to your personal checking account, you are taking a shareholder distribution. However you are not taxed on shareholder distributions nor are they a deduction to the business- you are taxed on income.
Here is a story to drive home this point- the Watson CPA Group has an S Corp client who had accumulated about $400,000 in her business checking account over the years. No big deal. Cash is king, right? Her husband called, and wanted to know the tax consequences of moving the $400,000 into their personal checking account since they were buying a house. We said None. You already paid taxes on the income that aggregated to $400,000 over the past three years.
Another way to look at this- cash that you take out (shareholder distributions, dividends, owner draws, whatever you want to call them) is not considered when determining your taxable income. Cash is cash and income is income. Sure, in most cash based businesses, cash will equal income and income will equal cash (or will be very close). But there can be a difference when factoring in non-cash expenses such as mileage and depreciation. The opposite is true with non-expense outflow items such as the principal portion of debt service.
Yet another example. Sorry to belabor this issue, but it appears this income versus cash continues to frustrate small business owners. Ok. Let’s say your S Corporation earns $100,000 after shareholder wages and expenses, and you magically also have $100,000 in the business checking account. You transfer $60,000 to your personal checking account as a shareholder distribution. $40,000 is left behind in the business checking account.
What is your taxable income? $100,000. Good.
Next year, your business is a bit slower and you only earn $50,000 and therefore you have $90,000 ($40,000 + $50,000) in the business checking account. You transfer $80,000 to your personal account leaving $10,000 in the business account.
What is your taxable income? $50,000 even though you transferred $80,000 from the business to you. Cash is cash and income is income. Over time, aggregated historical cash should be very close to aggregated historical incomes but don’t get too caught up on that. Same with accrual versus cash accounting- in looking back 20 years both accounting methods should converge in net incomes. We digress…
This is one of the dangers of owning a business- being taxed on reinvestments. For example, you have $100,000 left over at the end of the year and your taxable income is coincidentally $100,000. You took $70,000 in shareholder distributions as a return on your investment, leaving $30,000 behind for business growth (the reinvestment). If you are taxed at 30%, you will pay $30,000 (100k x 30%) in taxes on $70,000 worth of “cash flow” from your business- suddenly this becomes painful and a near-45% tax rate. Something to think about.
We’ve already discussed self-rentals and how you can pull money out that is only taxed at the income tax level. Expense reimbursements and fringe benefits are explored further in a later chapter on fringe benefits and tax deductions. Before we turn to the calculus of a reasonable S corporation salary, let’s briefly discuss the frequency of payroll.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition