Income Tax for S-Corp Owners: How much in taxes should you be paying?

Understanding how taxes are paid for an S corporation can be a bit confusing, but it’s important for business owners to have a good grasp of this concept. Here’s a breakdown of how it works:

What is an S-Corp?

First, it’s important to understand that S corporations are pass-through entities, meaning that the company itself doesn’t pay taxes. Instead, the income or losses of the company are passed through to the shareholders, who report it on their personal tax returns.

When an S corporation earns money, it’s required to pay its employees (including owners) reasonable compensation for their work. This compensation is subject to payroll taxes (Social Security and Medicare) and is deductible for the company as an expense. 

Profits are distributed to shareholders as dividends

After paying reasonable compensation to employees, any remaining profits are distributed to shareholders in the form of dividends. Dividends are not subject to payroll taxes, but are subject to income tax. 

Now, here’s where the confusion can come in. Business owners may wonder why they can’t just distribute all of the profits as dividends and avoid payroll taxes altogether. The reason is that the IRS requires S corporations to pay their employees reasonable compensation to ensure that they’re not trying to avoid payroll taxes by disguising employee wages as dividends.

So, let’s say that an S corporation earns $200,000 in a year. The owner takes a salary of $100,000, which is considered reasonable compensation for the work they’re doing. The remaining $100,000 is distributed to the owner as a dividend. The $100,000 salary is subject to payroll taxes, while the $100,000 dividend is subject to income tax.

Work with a qualified tax professional to determine reasonable compensation

It’s important for S corporation owners to work with a qualified tax professional to determine what constitutes reasonable compensation for their work. This can vary depending on a number of factors, including the type of work being done, the industry, and the geographic location of the business.

In summary, S corporations are pass-through entities, meaning that the income or losses of the company are passed through to the shareholders, who report it on their personal tax returns. S corporations are required to pay their employees reasonable compensation, which is subject to payroll taxes. Any remaining profits can be distributed to shareholders in the form of dividends, which are subject to income tax. Working with a qualified tax professional can help business owners navigate this process and ensure that they’re in compliance with IRS regulations.