As an S Corp shareholder, you might wonder if your corporation can pay your personal taxes. The Internal Revenue Service (IRS) has strict rules about this, with significant tax implications. Let's explore when and how an S Corp can help with your taxes.
First, it's crucial to understand that S Corps, like other corporations, file their own tax returns, while shareholders report their share of corporate income or losses on their personal returns. However, there are situations where you might consider having your S Corp pay your personal taxes.
S Corp Compensation and Taxes
S Corps must pay their shareholders a reasonable salary for the services they perform. This compensation is subject to employment taxes (Social Security and Medicare, also known as FICA taxes). It's also income taxed at the shareholder's personal income tax rate.
If you're the only shareholder and employee of your S Corp, you might be tempted to have the corporation pay your personal income taxes. However, the IRS considers personal income taxes a personal expense, not a business expense.
Self-Employment Taxes
S Corp shareholders who work for the corporation are considered employees, not self-employed. Therefore, they are not subject to the 15.3% self-employment tax on their net earnings, as long as they receive reasonable compensation.
However, if your S Corp pays your personal income taxes, the IRS may contend that the corporation has provided you with an improper taxable benefit. This could result in additional income taxes and potential penalties.
Reimbursement of Tax Payments
Although S Corps can't pay your personal income taxes, they can reimburse you for costs you incur on their behalf. This includes tax payments, as long as the reimbursement is NOT considered taxable income.
To ensure the reimbursement is non-taxable, maintain detailed records of all expenses. Also, ensure the reimbursement is made promptly and is directly related to your services for the corporation.
S Corp Distributions and Shareholder's Basis
S Corp shareholders can receive distributions (dividends) from the corporation. These distributions can help offset your personal income taxes if they increase your share of the corporation's basis.
Increasing your basis reduces the capital gain when you sell your S Corp stock, effectively lowering your capital gains tax. However, distributions are generally taxed as ordinary income unless they are qualified dividends.
Basis Adjustment
Each shareholder's basis in an S Corp is adjusted annually by the corporate income and deductions allocable to the shareholder, plus any nondeductible expenditures.
For example, if your S Corp purchases equipment that depreciates over several years, your basis increases each year by the share of the corporation's depreciation that's allocable to you.
Qualified Dividends
Certain S Corp distributions may qualify as qualified dividends, taxed at lower long-term capital gain rates. To qualify, you must have held your S Corp stock for at least 60 days during the 121-day period beginning 60 days before the ex-dividend date.
Ensure the S Corp files Form 8937 to track qualified dividends and includes a statement on Form K-1 (Partner's Share of Income, Deductions, Credits, etc.) to inform you of the qualified dividend portion.
In summary, while S Corps can't directly pay your personal taxes, they can help you manage and potentially reduce your tax bill through reasonable compensation, basis adjustments, and qualified dividends. Always consult with a tax professional for personalized advice. As your business grows, consider diversifying your income streams and tax planning strategies to maximize your after-tax income.