Blog

Listen to the Podcast Here: 11. Tax Implications for S Corp Business Owners

If you’re a business owner who takes W2 wages from your S Corporation, that may not be your only taxable income. An S Corporation (S Corp) is a pass-through entity for tax purposes. What does this mean? It means that the net profit generated by your S Corp is not taxed at the corporate level but rather passes through to your personal tax return. However, this pass-through feature can sometimes catch business owners off guard when it comes to calculating their taxable income.

Something that is commonly misunderstood by business owners is that net profit from your LLC or S Corp passes through to your personal tax return. Many business owners who take W2 wages from their S Corp assume that is their only taxable income. However, if your business is profitable, that is far from the truth.

This net profit is the remaining amount after deducting business expenses and paying your salary. It represents the earnings that pass through to your personal tax return.

How Taxable Income Flows Through to The Tax Return

Let’s say your business is an S Corp and you pay yourself a W2 wage, but the business also has net profit at the end of the year that either remained in the bank account or that you paid out to yourself as distributions.

Both the W2 wages that you paid yourself and the business’ net profit pass through to your personal tax return.

On a 2022 Form 1040, the W2 wages go on line 1 just like any other employee.

What I find that many business owners get confused about is that the net profit of the business goes on line 8 of your 1040. And then on line 9 of the 1040, both of those income items, as well as any other income or losses, are added together to calculate your total income. This total income is then used to determine your tax liability.

Whether you pay yourself a W2 wage or not, Uncle Sam is going get his share.

FICA Taxes for W-2 Employees & Business Owners

So, if both your W2 wages and net profit from your business are taxable, why would you elect for your business to be taxed as an S Corp?

The power behind making an election to be an LLC taxed as an S Corporation is the ability to avoid some self-employment taxes.

Without going off on too much of a tangent, it’s important to explain self-employment taxes at a high level to help understand the concept of why you may, or may not, want to make an S Corp election.

Self-employment taxes consist of Social Security and Medicare taxes, which are commonly referred to as FICA taxes (Federal Insurance Contributions Act).

As a W2 employee of a business, you are subject to paying 6.2% of your wages into Social Security taxes. In 2023, the wage base limit for Social Security taxes is $160,200, meaning that’s the most amount of your income that would be subject to Social Security taxes.

Additionally, you’re subject to paying 1.45% of your wages into Medicare taxes (and an additional 0.9% Medicare tax on wages above $200,000).

Your employer pays another 6.2% of your wages into Social Security and 1.45% of your wages into Medicare.

So, as an employee, you’re subject to paying FICA taxes of 7.65% (6.2% Social Security + 1.45% Medicare) and your employer also pays FICA taxes of 7.65% on your wages.

As a business owner, you are responsible for paying both the employee and employer portions of Social Security and Medicare taxes – 12.4% for Social Security and 2.9% for Medicare, for a total of 15.3%.

Why Elect to Be Taxed as a S Corp?

As mentioned above, the power behind making an election to be an LLC taxed as an S Corporation is the ability to avoid paying some self-employment taxes.

To avoid paying self-employment taxes using an S Corp election, you must set a reasonable salary (which is not defined by any IRS guidelines) and then you can take other compensation as a distribution.

The salary, or W2, portion of your income is subject to self-employment taxes while the distribution portion is not subject to self-employment taxes.

It’s important to note that you still have to pay Federal, state, and local taxes on both salary and distributions, as we discussed above. This is another misconception that I hear from people who have made an S Corp election – they believe that they don’t pay any taxes at all on their distributions, which is not true. The fact is that you don’t have to pay self-employment taxes on your distributions, but you are still subject to income taxes.

It’s also important to note that you should be paying yourself a W2 salary. You can’t just take all of your income as a distribution to avoid paying self-employment taxes. Doing so is illegal and will end up costing you more in taxes and penalties if you’re ever audited.

Should I Choose S Corp Tax Status for My Business?

Whether or not you should choose S Corp tax status for your business is a nuanced discussion that you should have with your tax professional. And to be clear, we have not discussed all of the considerations of making such a decision in this article.

Not only do the tax implications need to be considered, but you also must factor in the costs of making an S Corp election such as an additional tax return, payroll, accounting fees, etc., not to mention your long-term goals and how S Corp taxation may or may not be beneficial to achieving them.

I hope this article has shed light on an important aspect of taxable income that is often overlooked by business owners who take W2 wages from their S Corps. Navigating the intricacies of business taxation can be challenging, but having a firm grasp on the tax implications of W2 wages and net profit is essential.

As a business owner, it’s crucial to recognize that both forms of income contribute to your overall taxable income. By properly reporting and understanding how these incomes affect your personal tax return, you can ensure compliance with tax regulations and avoid potential issues with the IRS.

As always, it’s advisable to consult with a qualified tax professional to ensure you navigate the complexities of taxation smoothly.