Most of the time I recommend an S Corporation or an LLC that has elected to be taxed as an S Corporation for business owners. There are two different ways you can take money out of the S Corporation: as a salary and as a distribution. (You can also take a loan, more about that in a minute.)
I received this question at USTaxAid regarding S Corporation distribution:
Q: I file as an S-corp. Is it accurate that if I take some of my business profit in “owner’s draws”, this money is not subject to self employment tax?
A: The answer is almost always “it depends.”
If you have an S Corporation with profit, and its not your first year in business, the IRS is going to want to see that you’ve taken a salary from the company. It’s tempting to skip that, because running a salary for your company the first time cane be a paperwork nightmare and you’re going to have to pay state and federal payroll taxes.
But if you skip this, and instead decide to just take out a distribution, the IRS might decide that ALL of your company income is salary. And that means you pay salary on all of it.
Normally, though, you take a salary and pay payroll tax. That salary and payroll tax are deductions from the corporate income. You may take a distribution, or you might not. It doesn’t matter for tax purposes because you pay tax on the corporate income.
There is no self-employment tax or payroll tax (subject to the warning at the beginning of this blog) on the distribution.
One more warning, though. If you take a distribution in excess of the profits, you are going to face tax on the excess. That’s why you usually want to have part loan if your distribution is too large.
S Corp dividends or distributions might look easy, but there are a couple of things to watch to make sure you don’t run into extra tax by mistake.