Is double taxation “fair” to corporations and shareholders?

How should S Corporations reimburse their shareholders for changes in taxes?

• As you may know, an S Corporation is treated legally as a corporation, but is treated taxwise much more like a partnership. An S Corporation prepares a tax return (1120S) which it files without a payment. The S Corporation prepares for each of its shareholders a Schedule K-1, which is basically that shareholder's prorated (based on percentage of ownership) part of the corporation's return. I am one of two owners of an S Corporation. I handle the accounting and tax returns for the company. Assuming that the company posts a profit, the shareholder owes more tax than they would without the company's Schedule K-1 (likewise, if the company posts a loss, the shareholder owes less tax - as long as the shareholder's basis does not hit zero.) * How do S Corporations typically handle the increased or decreased tax amount in the shareholder's tax return? Although I handle the accounting and tax returns for our company, we do have a CPA that we consult with occasionally. He was able to tell us that the S Corporation typically writes the shareholder a check to cover the difference in the tax return (or receives a check from the shareholder if the S Corporation posted a loss assuming the shareholder's basis does not hit zero.) He was unable to tell us the specifics of how this works. * If this method is not typical, is this method of "reimbursement" acceptable accountingwise and taxwise? * I can handle the accounting entries. What tax entries need to be made? I am certain a disbursement of funds like this would not be counted as taxable income for the individual (stopping tax on already taxed money is one of the points of an S Corporation.) Assuming that it is acceptable for each shareholder to prepare a tax return with and without the company (both shareholders use TurboTax, neither minds), and settle with the company on the difference, which of last tax year's returns should the shareholder use for any carryover information? (The last year return that was actually filed with the Schedule K-1, or the prepared one for comparison purposes only without the Schedule K-1?)

• Answer:

  Hello and thank you for your question. As you know, your company's sub-S election makes you and your co-shareholder responsible for paying the income tax on essential all of the company's profits, whether or not the company actually distributes any of those profits to you during the year. There are basically two approaches to handling the tax situation. One would be for the two of you to draw salaries and cash bonuses from the company on an agreed basis between you, in an amount sufficient to eliminate the company's income. In other words, despite the sub-S election, the company is allowed an income tax deduction for all of its "ordinary and necessary" business expenses, including reasonable compensation to the two of you for the services you render to the company. This is actually the method that the IRS favors, because it gives the government the opportunity to collect FICA (Social Security) tax on the compensation payments in addition to income tax. Officer Compensation http://www.withum.com/Articles/Officercompensation.shtml Alternatively, and especially if you two are not also the key employees of the company, you can draw smaller (but still reasonably adequate) salaries, which will allow profits to accumulate in the company. Then, the mechanism that you need to provide the two of you with funds to pay your income taxes on these profits, is to declare and pay corporate dividends in an agreed amount. Although dividends do not reduce the company's taxable profits the way compensation does, the sub-S basis rules are designed to allow this mechanism to work. "[A] shareholder's basis in S corporation stock is dynamic. In addition to capital contributions..., profits increase basis in the shares. Distributions and losses decrease basis." Choice of Entity http://www.staleylaw.com/images/Choice_for_EP_102503m.pdf "A distribution made by a Subchapter S corporation, as defined in 26 U.S.C. 1361, to its owners, including a distribution intended to cover a shareholder's personal tax liability for the shareholder's proportionate share of the taxable income of the institution, is considered to be a capital distribution under this rule." http://www.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=1998_register&docid=:fr07ja98-32 Since the two of you are equal shareholders, each $1.00 of dividend will be allocated 50 cents to each of you. I do not think you need to concern yourself with each other's tax brackets, NOL history and the like. Even if the two of you are in different tax brackets (because one of you has more outside income, different personal tax deductions, etc.) there is no reason the distributions should not be equal between you. Otherwise it would be as if in setting salaries for each of you, you tried to take your respective income tax brackets into account. This is never done in any other business entity (C corporation, partnership, LLC) nor is there any reason to do it here. Anyway, chances are each of you are in approximately a 35% tax bracket anyway (more or less depending on the state you live in, since you will also incur state income tax, assuming that your state like most follows the federal sub S rules), so a good rule of thumb will be to distribute at least one-third of the profits, or any larger amount if the cash needs of your business make such distributions practical. You also asked about the proper treatment in years that the company generates a tax loss. Unless the company needs extra cash, I see no reason why the two of you should feel obligated to contribute the tax savings to the company (although you could if you wanted to, since the contribution would increase your tax basis in the shares so a future distribution in effect a return of that capital could be made tax-free at a later date). Again I suggest that you mainly consider the cash needs of the company in deciding how much cash should be held in the company accounts, rather than the factors alluded to in your question. Search terms used: sub-s compensation shareholder planning compensation shareholder "subchapter s " site:.gov Thanks again for bringing us your question. If you find any of my answer unclear, please request clarification. I would appreciate it if you would hold off on rating my answer until I have a chance to reply. Sincerely, Google Answers Researcher Richard-ga