Duluth/Snellville/Grayson CPA: Understanding S Corporation Taxation
At His CPA PC, we work hard to unwind the complexity of tax law and to help Atlanta taxpayers understand their rights and responsibilities as an S Corporation owner. Having been an Atlanta CPA for decades the S Corporation election generally will result in the lowest legal tax possible for a majority of business owners (however don’t rush to make a decision, make sure you seek a CPA’s wisdom before you incorporate). The below is a sample letter we might receive from a client seeking to understand the cause and effect issues of entity selection:
It just occurred to me that I am paying taxes on the profit reported on the K-1 from the business and I never got any of this money? I would like to discuss how I can move forward to ensure that I am not paying taxes on money that I am not receiving (despite my 49% ownership).
Below is my response:
S Corporation Taxation
Although there is no income tax paid by as S Corporation when the annual tax return is filed to the IRS. However, as a part of the corporate return which is prepared, a Form 1120S, there is an attached schedule which shows each owners respective ownership percentage and via a Form K-1 for which each shareholder should reflect on their personal return. K-1 profits, losses, and shareholder distributions are all required by tax law to be issued based upon the each shareholders ownership percentage.
By tax law S Corporation owners are required when they make shareholder distributions based upon ownership of the business. For example if the S Corporation were to issue a Shareholder Distribution for $10,000 you would receive (based upon your 49% ownership) $4,900. Generally though:
• Unless you have a shareholder agreement there is no requirement that an S Corporation issue distributions.
• Generally it is prudent for all S Corporation owners to receive enough in distributions to cover the tax liability that will be due on the K-1 for both their federal and state income taxes.
• It is prudent to have a shareholder agreement in place that would cover such including other issues such as the terms and conditions under which decisions are made, what happens when shareholders leave the employment of the company either for “with cause” or “without cause.” Also the methodology of how value of the company would be determined in the event of death, disability or cessation of employment and the payment terms thereof.
If you have losses in your S Corporation, for them to be deductible a shareholder has to have a positive tax basis, which is a component of past profits, losses, and loans to and from the business. If a shareholder has no basis to cover losses reported on a K-1, they are by tax law considered to be “suspended losses” and can be rolled forward to future years when the shareholder has positive basis, which can be created by future years profits or the shareholder loaning money to the business.
An S Corporation owner will report the K-1 profit, which is based upon their share of the business and not the amount of their shareholder distributions. This is a common misnomer about S Corporations and often leads to confusion for the new business owner. To that end it is best to remember that you pay taxes on the profits when you make them and not when you take them. For example generally speaking if your business nets $100,000 and you are the sole owner, you will pay taxes on $100,0000 whether you take zero dollar of shareholder distributions, a $100,000 or any number in between. Thus if you were to have a $100,000 profit in any given year and take no distributions then you would be able, absent any other issues, to take shareholder distributions in subsequent years with no additional tax responsibility as these monies would have already been taxed.
There are only four and many businesses will qualify. To be an S Corporation you must have:
• Have a December 31st year-end.
• Have less than 100 shareholders.
• Shareholders have to be U.S. citizens or resident aliens.
• Only one class of stock.
Although most states recognize and reflect the same tax treatment for S Corporations as the IRS and charge a relatively insignificant net worth tax such as Georgia, there are many states which charge a franchise tax as well.
Incorporating in Georgia
Carefully considering the tax effects of your entity choice is essential to getting your business off on the right foot. Being careful to avoid, if at all possible, the double taxation of C Corporations and then selecting the right entity for your business from both a tax and legal perspective is critical. See http://www.hiscpa.com/article6.html
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