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Ask Lane Your Own Question
Category: Tax
Satisfied Customers: 10135
Experience:  Law Degree, specialization in Tax Law and Corporate Law, CFP and MBA, Providing Financial & Tax advice since 1986
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I am the new owner/employee of an LLC with S-Corp election

Customer Question

I am the new owner/employee of an LLC with S-Corp election and i am wondering if it is a good or bad practice to take shareholder's distributions throughout each month to pay yourself and then at the end of the month to reclassify 70-80 percent of those distributions as wages? I researched that i could reclassify the distributions as wages by usinf Advance Pay type of deduction on the paycheck to make the NEt Pay equal zero, but reflecting the gross pay with all the required withholdings. Is it normal for the S-corp with unstable fluctuating income, like myself? Or should i just switch back to Sole Propritorship for tax purposes to avoid all the potential problems with S-corp salary requirement? Thanks for any information. Greatly appreciated.
Submitted: 1 year ago.
Category: Tax
Expert:  CGCPA replied 1 year ago.
If you are the only owner of the LLC you are required to file as a sole proprietor using Schedule C of form 1040. If that is the case there will be no payroll/payroll taxes for you. If that is not the case you can take a small yet fixed salary every week with bonus payments as the funds are available. This will remedy the concerns. Additionally, just because you receive a salary check does not mean you must cash it. If the funds are not available you are permitted to hold it. I would go with that route using say $150-$250 per week as the gross.
Customer: replied 1 year ago.
So you do not advice taking dustribitions multiple times a month and reclassifying them as salary at the months end? Say I made 10000$ in profit in a month, and taken out all of it as dustribitions, can I then reclassify 7000$ as a salary (paycheck issued will net zero)?
Expert:  CGCPA replied 1 year ago.
I would take a small but regular salary and take distributions as funds become available and you need them. The difference is that a regular small but reasonable salary will be taxed as a regular payroll tax (state and federal unemployment, employer and employee side Social Security and Medicare taxes) while distributions are not taxed as taken.
For example, if you take a salary of $200 per week ($10,400 per year) and distributions of $30,000 spread unevenly over the course of the year the salary will be subject to the taxes mentioned above while the distributions will not be taxed. Remember, however, that S Corporation owners are taxed (income taxes only) on the net business profit or loss of the S Corp. This net profit/loss is after deducting the salary expense.
Customer: replied 1 year ago.
Apparently you are not aware of the reasonable salary rule: I can't pay myself only 10000$ a year.... And your suggestion of taking 30000$ of dustribitions is also wrong. The proportion between salary and dustribitions should be reasonable (70/30, for instance). I'm still not getting the response to the eligibility of using advance pay deduction on paycheck at the end of month to reclassify dustribitions to salary.
Customer: replied 1 year ago.
Can you please refer my question to a different expert, as I am still not satisfied with the answer.
Expert:  Lane replied 1 year ago.
Hi,Different expert here.First, IRS is very forgiving for a RELATIVELY low salary in the first year. That 70% of new businesses fail (although this has evolved over the years) has led them to understand that profitability for the first (even first two or three) can be very unpredictable ... and taking a salary VERY small (to negligible) salary when it's possible that a profit will not even manifest is now considered a best practice..I THIS expert's opinion, I'm not sure why you'd want the administrative overhead of payroll taxes, quarterly 941's, paying in FICA at least monthly, not to MENTION this recharactizion of distributions as salary along the way ... when you can simply err on the low side with the salary - or even wait until it's obvious that you'll BE profitable before starting to take one..REASONABLE DOES NOT mean 70/30, Reasonable means reasonable given all the "facts and circumstances," as IRS would say. (What others with your same skill and experience would earn as employees, the amount of responsibility you're assuming, risk assumed - as in the CEO's risk for a compoany's operations, BUT profitability is also one of the considerations. Keeping it low and rampiing up as you have the benefit of more information is not only OK, but again, a best pracrtice)..In terms of your questions about sole proprietor, I would recommend something different; an LLC. The LLC provides the corporate liability protecttion of the Corporation but the flexibiity and ease of operation of the sole proprietor. (That's ONE of the reasons the LLC is the fastest growing entity out there)..The only reason to TAKE ON all that administrative overhead (and rigidity) of the S-Corp is to save on Self Employment taxes. As a self employed individual (that's a specific term - meaning sole proprietor, single member LLC or partner in a partnership). YOU pay both halves of the SS & Medicare (as Im guessing you know) in the form of Self-Employment tax of schedule SE... But as a sole shareholder/employee of an S-Corp that only becomes different at high levels of profitability....... You have to do the SS & Medicare withholding from your salary and then the S-Corp (YOU) pays the other half - (again, paying - in every month) -It's only when you get well above that salary PLUS other expenses of the S-Corp that the profit over and ABOVE those expenses are sent via the K-1 and NOT charged the SS & Medicare..So I RARELY reccommend an S-Corp out of the gate ..., CPA's love 'em becasue they want to DO that payroll, 941's FICA pay-in's etc. for you (FOR a price) .. but, again, until you get WELL over (in profit) what might be considered reasonable when operating predictably PLUS the other business' deductions, that S-Crop administrative "schtuff," is just headache, administrative overhead, and payroll tax risk..Start as an LLC, (probably a 100 bucks on your state) and then once you see that you're really there AND want that extra administrative overhead, file the form 2553 to be elected as an Sorp (once 15.3% of your EXCESS profits over salary & expenses becomes enough to offset the additional cost, headache and payroll risk..Finally, regardng the cost and headach of th reasonable salary issue - see this from a Journal of Acc**tanty issue""Published opinions from recent Tax Court cases have put a heavy emphasis on the use of comparability data to determine market rates of pay. When comparing one person’s pay to that of others in the same industry who have the same title, the IRS may conclude that a shareholder was underpaid. An adjustment to one shareholder’s pay may result in penalties for failure to withhold taxes and failure to deposit taxes. Furthermore, an adjustment to just one shareholder’s pay could cause distributions for that period to become disproportionate. Since S corporations are generally required to make distributions to shareholders on a pro rata basis (based on stock ownership), an increase in one person’s pay, with a corresponding decrease in that shareholder’s distributions, could create disproportionate distributions. In a severe case, disproportionate distributions could terminate the company’s S status.When no compensation at all is paid to shareholders, encourage the filing of payroll tax returns anyway, even if the forms show zeroes. Then, if the IRS determines that some compensation should have been paid during those periods, the company should at least be able to avoid the stiff penalty for failure to file payroll returns.".So NOW, you see that experts are recommending that you do payroll taxes even when the number are zero..Why would on DO that? when there's no tax savings anyway?..For the life of me (other than CPA's needing work) I can see WHY everyone wants to be an S-Corp
Expert:  Lane replied 1 year ago.
Oh yes, ... meant to provide that J of A Article for you: me know if you have questions from here:.Lane.If this HAS helped, I would appreciate a positive rating (using the stars or smiley faces on your screen)… That’s the ONLY WAY I'll be credited for the work here, Thanks! … However, if you need clarification, or want to discuss this issue further, be sure to come back here, so you won’t have to pay for an additional question.
Expert:  Lane replied 1 year ago.
...just checking back in to see if that new information was helpful.
Let me know if my answer helped.