This blog post will not touch most of you, but, for those of you it does touch, it will be very important. As a fee-only advisor, I work with many different types of business owners, and today’s post is meant for those who own S Corporations.
More and more small business owners are establishing their businesses as S Corporations. This business structure has several benefits, but it also has some pitfalls that can lead to unexpected taxation.
As a pass-through entity, an S Corp passes along income (and losses) to the business owner. Generally, an S Corp doesn’t pay tax at the entity level (the business) because it passes income through to the business owner where it’s taxed at the personal level.
There are two ways an S Corp business owner can pay himself: either as a shareholder distribution (considered a dividend) or through payroll as an employee.
One of the benefits of an S Corp is income that is passed through to the business owner in the form of a shareholder distribution (dividend) will avoid payroll taxes. For example, a business owner who pays himself a $50k payment (considered a dividend) from business profits can avoid payroll taxes on this payment, which may generate several thousand dollars in savings. But, a dividend payment to the business owner may generate additional taxes for Tennessee Residents.
This dividend payment may factor into Franchise and Excise taxes, as well as, the TN Hall tax (income tax), which are levied at the rate of 6.5% and 6% respectively. So, a simple business dividend payment could end up costing a business owner 12.5% in taxes….that’s $6250.00 on the $50k example.
Most often in this situation it may make more sense for the business owner to simply pay themselves through payroll as an employee.
While there are several nuances to S Corp taxation and this is by no means a total pros and cons comparison, it simply illustrates the complexities of an S Corp. It’s extremely important to proactively review S Corp taxation and how it impacts the business owner’s bottom line. Sometimes what may seem like a benefit may actually turn into a liability.