S Corporation Owner/Employee Reference Guide
The following is to provide guidance on the taxation of an S Corporation owner/employee, highlighting differences in the transition from an employee to an owner/employee.
Employee Wages and S Corporation Pass-thru Income
As an employee of an S Corporation, the taxation to an individual is through compensation. The compensation received, as well as the federal and applicable state income tax withheld, is reported on an individual’s annual personal income tax return through the receipt of Form W-2.
As an owner/employee of an S Corporation, an individual is taxed via compensation per above, but will also receive a share of the S Corporation taxable income or loss based upon the percentage of stock ownership of the S corporation. The owner/employee will receive Form W-2 for their compensation and a Schedule K-1 for the reportable share of S Corporation income. This income is reported on Schedule E, page 2, of Form 1040.
S Corporation Distributions versus S Corporation Income
As stated above, S Corporation taxable income is allocated to shareholders based upon stock ownership. Cash distributions from the S Corporation are allocated in the same manner. The receipt of a distribution is based upon cash availability and should not be considered a representation of allocable taxable income. Also, cash distributions may not coincide with the period that taxable income is earned.
Taxable income allocated to shareholders and cash distributions to shareholders will almost always differ. This occurs as certain cash disbursements are not an income tax deduction (loan payments, asset purchases) and certain items that affect income will not affect cash (depreciation).
Separately Stated Income and Expense Items
As the S Corporation is merely a “pass-thru entity” (it does not pay income tax), the income from the S Corp is separated into different components that can be reported on the owner/ employee’s personal income tax return. These include, but are not limited to:
• Ordinary income
• Interest income
• Dividend income
• Capital gain or loss
• Rental income
• Charitable deductions
• Non-deductible items
The separation of these items at the S Corporation level is necessary as each may have specific tax treatment at the individual level and may be taxed at different rates.
Also, if a shareholder has greater than 2% ownership, the IRS requires that certain items such as health insurance and other fringe benefits be included in the shareholder’s W-2. This differs from being an employee only.
Withholding and Estimated Tax Payments
The wages that are received by the owner/ employee will continue to have federal and applicable state withholding. This is referred to as “covered income”. The taxable income allocation from the S Corporation does have a vehicle to allow for withholding, thus it is “uncovered”.
The owner/employee will receive Schedule K-1 (reporting the S Corporation taxable income/loss) subsequent to the year in which the income was earned. Unfortunately, the IRS requires that the owner/ employee pay the income tax on this during the year that it was earned. Depending upon the magnitude of the taxable income allocation, the income tax on this “uncovered income” can be paid through quarterly estimated payments, or by adjusting the withholding on wages. This is generally completed through quarterly estimated payments. This can be accomplished via withholding if there is a substantial end of year bonus for which a significant portion can be devoted to federal and state withholding.
Individual estimated payments for a given calendar year are due on April 15, June 15, September 15, and January 15 (of the following year). The Federal and State taxing authorities require that the combined withholding and estimated payments meet certain requirements on a quarterly and annual basis. If these requirements are not met, underpayment penalties will apply.
The information stated above will hopefully provide an overview of the taxation of an owner/employee. Other specific questions can be addressed with each individual.
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