Distributions from Partnerships and S-Corps

On several occasions, the following scenario has played itself out in my office: client comes in very excited, exclaiming that they are "going out on their own".  We file all the necessary paperwork to get an employer identification number, articles of incorporation, and have a quick run-through of how to keep up with income and expenses.  Then, they are on their merry way.

About a month later, the client calls and asks "how do I pay myself?"  

This is a common issue for small business owners, especially when they are set up in partnerships or S-Corps.  To begin, partners in partnerships typically do not draw salaries, and S-Corp shareholders only draw "reasonable compensation" during the year.  The remainder is taken by the partner/shareholder as a distribution, loosely defined as taking cash out of the business.  

Here is an example.  Jim is the 100% shareholder of Jim's Tools Inc, an S-Corp.  For the year, Jim has taxable profit of $100,000.  Of that, he pays himself a salary of $30,000, leaving the company with a $70,000 profit.  Jim will pay taxes on both his $30,000 paycheck and the $70,000 profit of the business on his personal return.  Assuming he is in the 25% tax bracket, his tax burden will be $25,000 ($30,000 paycheck + $70,000 business profit x 25% tax rate).  Based on these facts, he is permitted to distribute up to $70,000 of cash from the business to himself.  At the end of the day, he is left with $75,000 in his personal bank account after paying taxes.  

Partnerships work in a similar way, minus the salary.  The big difference is that the income from a partnership is likely to be subject to self-employment tax, since there is no salary involved.  In an S-corp, the shareholder will pay self-employment tax (payroll taxes of FICA and Medicare) on their paycheck.  Since a partnership does not pay a salary to the partner, the partner is responsible for this on their personal return.  But, distributions work the same way: if a partner has net profit for the year of $100,000, they will pay ordinary and self-employment tax on that money, but will be permitted a distribution up to $100,000.  

The main thing to remember is that S-Corps must pay a reasonable salary during the year to its shareholders, which is the tradeoff for the net earnings from the S-Corp not being subject to self-employment tax.  Partnerships and S-Corps should also keep track of their distributions during the year for reporting on the tax return at the end of the year.  

Why mileage?

When it comes to cars, self employed individuals and small business owners usually have the same two questions: how much of the initial purchase can I write off, and should I keep up with mileage or actual expenses?  I will address the first question in a later article once Congress retroactively increases the depreciation limits for 2015.  The second question is a little more straightforward but with a few special circumstances to consider.  

Taxpayers that use a vehicle for business purposes and are not eligible to be reimbursed for their expenses can deduct either mileage or actual expenses on their tax return.  This is especially handy for self employed individuals that spend quite a bit of time in the car, such as real estate agents or commercial salespeople.  Often, taxpayers assume actual expenses will generate a higher deduction, but that is not always the case.  

Consider this: taxpayer drives a Toyota Camry that has a 17 gallon gas tank and gets 25 miles per gallon on average.  Assuming gas is $2/gallon, that means the taxpayer could drive 425 miles for $34.  The mileage rate for 2015 is 57.5 cents per mile, which means that same 425 miles would generate a $245 deduction using the standard mileage rate.  In this case, mileage is a much better method to use than actual expenses, and that will almost always be the case when the taxpayer has a fuel efficient vehicle in an environment of low gas prices.  

There are a few precautions to take when deciding whether to use actual expenses or mileage on a vehicle.  One is once the decision is made, it usually cannot be changed in the future i.e. a taxpayer cannot take actual expenses one year and mileage the next.  Another is the historical trend that the IRS is usually 1-2 years behind in aligning the mileage rate with expected actual expenses.  The mileage rate is designed to be one number that covers gas, maintenance, and depreciation on a per-mile basis.  From 2014 to 2015 the standard mileage rate increased 1.5 cents, while average gas prices decreased.  It can be expected then that the 2016 rate most likely will be less than 57.5 cents per mile due to the decrease in gas prices, but that will not necessarily be consistent with gas prices in 2016 (which could go up).

Mileage rates for 2016 are expected to be released close to the end of the year (December 2015).  My guess is 55 cents per mile.   

The "be your own boss" tax

Being your own boss can be fun and rewarding.  But, whether you own a small business, run a custom quilting operation from your home or write editorial articles for fun, taxpayers need to be aware of the self-employment (SE) tax.  

The SE tax is imposed on taxpayers that report SE income on their individual Form 1040.  The purpose of the SE tax is to recoup Social Security (FICA) and Medicare taxes from taxpayers that do not pay these through paycheck withholding.  When a taxpayer is an employee, it is their employer's responsibility to withhold these taxes from their paycheck and remit them to the government.  But, since self-employed taxpayers do not receive a "paycheck" per se, they must pay these taxes when they file their individual Form 1040.  

What types of income are subject to the SE tax?

Before calculating SE tax, the taxpayer must first determine how much SE income they have.  Common types of SE income include:

• Rental income
• Net profit from sole-proprietorship or single-member LLC (reported on Schedule C)
• Nonemployee compensation received and reported on Form 1099-MISC, such as contract labor, commissions, or bonuses.

Note that rental income is included above.  If rental income is passed through to the taxpayer on a Schedule K-1, then the K-1 should indicate whether the activity is passive.  If it is passive, then it is subject to the SE tax.  

How much is it?

As mentioned above, the purpose of the SE tax is to recoup Social Security and Medicare taxes.  The Social Security rate is 12.4% on all SE income up to $113,700, and the Medicare rate is 2.9% with no upper income limit.  The total amount of tax will be reported in the "Other Taxes" section of the Form 1040, but 50% of the amount reduces the taxpayer's AGI as an adjustment to income on page 1 of the Form 1040.  Here's an example:

Marty makes and sells custom coffee cups at his home.  He is not incorporated, and his net profit for the year was $75,000.  He will pay total SE tax of $11,475, made up of $9,300 in FICA (75,000 x 12.4%) and $2,175 in Medicare (75,000 x 2.9%).  He will get an adjustment to income in the amount of $5,738 ($11,475 x 50%)

But what if Marty makes really awesome coffee cups?  

Marty had the most successful year of his coffee cup career, showing net profits of $200,000.  Marty will pay total SE tax of $19,899, made up of $14,099 in FICA (113,700 x 12.4%) and $5,800 in Medicare (200,000 x 2.9%).  Notice how the FICA taxes are capped at $113,700, but Medicare is charged on the full amount.

Options to reduce or eliminate SE tax

Taxpayers can reduce their SE tax burden in various ways.  One way is through business structure.  Taxpayers that have substantial business income, such as Marty above, can consider incorporating and filing an S election.  As an S-corp, Marty could pay himself a reasonable salary for the year which would have the required payroll taxes withheld, and the remaining profit would be passed through to him on a Schedule K-1 as ordinary income not subject to SE tax.  If his salary was $100,000 and the other $100,000 was passed through to him on a K-1, Marty would save almost $10,000 in SE taxes.  Marty could also elect to be a normal C corporation, and all the profits from the business would be taxed at the corporate level.  Although this would eliminate the SE tax for Marty, corporate rates are not as favorable as individual rates and the taxpayer could end up paying more in corporate taxes.  

Taxpayers that generate SE income from their home should consider the Home Office Deduction.  The IRS now offers a simplified calculation for smaller operations, but taxpayers with a significant home office should go through the full calculation to reduce their SE income.  

Taxpayers can also reduce their regular tax burden associated with SE income by making contributions to retirement plans.  A traditional IRA is the easy way to go, but taxpayers with higher amounts of income and cash flow should consider a SEP (simplified employee pension).  The SEP will allow contributions up to 25% of SE income, with a maximum of $51,000.  However, the retirement contributions reduce the amount of taxable income, but not the amount of SE income.  In Marty's case above, he would have regular taxable income of $50,000 less after making a SEP contribution, but his SE tax would not change.