Which is Best in an S Corporation: Distribution or Salary?

What Are S Corp Distributions?

Ask a CPA and they’ll tell you S Corporation distributions are not the same as S Corporation dividends. To clarify, distributions are made to all shareholders at the end of any given tax year, based on profits made and percentage of shares owned. Distributions are not mandatory and can be kept in the common stock account or accumulated adjustments account. Distributions are not taxed.

Dividends, on the other hand, may be dollars paid to each shareholder throughout any given tax year, usually in conservative amounts. Each shareholder, regardless of stock percentage of ownership must receive the exact same dividend and dividends are also not taxed.

Why Aren’t Distributions and Dividends Taxed in an S Corp?

Unlike other corporation entities like C corporations that have retained earnings, S Corporations have what is called an Accumulated Adjustments Account, or AAA. Distributions and dividends paid to shareholders are not taxed if the following occurs:

• The AAA Account must be in a positive position at tax year-end.
• The distributions paid are not to shareholders but directly to their capital or stock accounts.

The Accumulated Adjustments Account is much like a running total of cash investments and cash dividends and distributions going out. It is not the percentage of stock the shareholder owns. For example, if an S Corporation were opened by John Smith who owned 30% of the stock and Jane Smith who owned 70% of the stock, those stock positions do not change, however cash contributions in and out do affect the AAA account and how the company’s year end profit (or loss) is calculated. In this example, profit or loss distributions at the end of a tax year would be split 70%/30% between the Smiths. Dividends, if paid, would have to be in the same amount regardless of common stock shares owned.

Distributions and dividends paid are not reported on standard 1099 forms in an S Corporation, but are reported on the company’s 1120S tax return to the IRS. These distributions can affect the profit or loss of the company in a tax year and those profits or losses are what shareholders pay tax on. An S Corporation is a pass-through entity, so at the end of the tax year, shareholders receive a K-1 to include with their personal return showing any profit or loss for the company. It is at this level that tax comes into play.

Why You Need a Salary in an S Corporation

The S Corporation is a tricky beast and when company owners found this way to incorporate their businesses, many jumped on board. The reason? Unlike C Corporations where both the company and the shareholders are taxed on profits, the S Corporation is a pass-through entity meaning any profits or losses are passed-through to the shareholders in the form of a K-1 earnings (or loss) statement to include with their personal income tax return.

Because shareholders of an S Corporation may have interests in more than one company and many investments, losses from an S Corporation in the form of a K-1 to the shareholder were too often used to off-set gains in other companies so the shareholder could reap the reward of a tax refund, leaving really no tax paid for the corporation. This alone is why S Corp distributions or salary is important to keep your business safe from suspicion.

A sure way to find your S Corporation on the IRS to audit list is to not pay the person who is in charge of running the day-to-day operations of the S Corporation a salary.

Why? Because the IRS knows that through distributions, dividends, and losses from S Corporation K-1’s to shareholder, there is really no tax, especially Social Security and Medicare tax being paid even though shareholders are receiving income. Beyond the IRS being wary of negating a salary by an S Corporation operating manager, most states are also aware of this problem and will hold in suspect any S Corporation that has no wages paid to the operating manager or at least one of the partners or stockholders.

Who Should Receive the Salary in the S Corp?

To determine who should receive a salary in the S Corp, especially if you have more than two shareholders, look at what each shareholder does for the company. If the shareholder is involved in the day-to-day business operations and is present at the business each day, they should receive a salary, with the appropriate federal, state, social security, and Medicare taxes deducted. They should also receive a wage and earnings statement or W-2 at year-end along with regular employees of the corporation.

As far as the amount of the salary you should pay the operations shareholders, consider your gross annual sales, not your net profits (or losses). If you are reporting gross annual sales of $500,000 and you are paying operating shareholders $10,000 per year, less taxes, that’s a red flag to the IRS. Base your salary on what it would cost you to hire an employee to do what you do and pay a fair salary that is not understated. When asking in an S Corp, distribution or salary, make sure to you ask your CPA or accountant to explain to you what qualifies as a distribution, a dividend, and a fair salary.