The 60/40 rule is a simple approach that helps S corporation owners determine a reasonable salary for themselves. Using this formula, they divide their business income into two parts, with 60% designated as salary and 40% paid as shareholder distributions.
S Corps that lose their “S” status must typically wait five years before being able to re-elect it. As mentioned, deliberately violating one of the rules, such as transferring stock to an ineligible shareholder, is not a good thing.
The Internal Revenue Service (IRS) requires that S Corporation shareholders who perform significant services to the business be paid reasonable compensation. As a small business owner, if you work for your S Corporation, you must pay yourself reasonable compensation for your work.
Another common rule, dubbed the S Corp Salary 50/50 Rule is even simpler, with 50% of the business income paid in salary and 50% in profit distribution. However, the salary you end up with using these kinds of rules is arbitrary and may not pass muster with the IRS.
Ownership. The IRS rules restrict S corporation ownership, but not that of limited liability companies. IRS restrictions include the following: LLCs can have an unlimited number of members; S corps can have no more than 100 shareholders (owners).
The right time to convert your LLC to S-Corp
From a tax perspective, it makes sense to convert an LLC into an S-Corp, when the self-employment tax exceeds the tax burden faced by the S-Corp. In general, with around $40,000 net income you should consider converting to S-Corp.
At the end of each year, all S corporation profits are allocated to the corporation's shareholders. Even if you and your fellow shareholders choose to leave some or all of the profits in the corporation, taking nothing as distributions or salaries, you will still be required to pay tax on those profits.
For tax efficiency, most company directors will choose to pay themselves a low salary and take any further money from the company in the form of dividends. This is because dividends are taxed at a lower rate than salary, and avoid national insurance contributions.
And if the IRS and/or the courts find that your S corporation did not pay you reasonable compensation, you can experience a new surprise salary, payroll taxes, and penalties. This will make your bad year worse.
Because of the one-class-of-stock restriction, an S corporation cannot allocate losses or income to specific shareholders. Allocation of income and loss is governed by stock ownership, unlike partnerships or LLCs taxed as partnerships where the allocation can be set in the partnership agreement or operating agreement.
Give Yourself A Loan From the S Corp
If you borrow money from the corporation (via a loan), you're never going to have capital gains. However, even if you list your withdrawal of funds as a loan on your financial statements, the IRS can recharacterize it as a distribution.
S corporation disadvantages
Limited number of shareholders: An S corp cannot have more than 100 shareholders, meaning it can't go public and limiting its ability to raise capital from new investors. Other shareholder restrictions: Shareholders must be individuals (with a few exceptions) and U.S. citizens or residents.
Augusta Rule Recap
Applies to entities that are taxed as S-Corp and C Corp. The concept relates to income shifting from the business to the business owner. Allows the business to hold meetings up to 14 days and deduct the rental expense, thereby lowering the total income that is being taxed at the current tax rate.
An S Corp, like a C Corp, must have a board of directors. Directors represent the company and make decisions on behalf of the shareholders. If your S Corp has more than three shareholders, you'll need to appoint at least three directors. S Corps with fewer than three shareholders must have a director per shareholder.
Shareholder Approval
S-corporation dissolution always starts with a formal shareholder vote, as outlined in the company bylaws, which usually requires a majority (50% shareholder votes) or supermajority (two-thirds [66.7%], three-quarters [75%], or more) to pass.
Transferring funds from a single-member LLC business account to your personal account is generally treated as an "owner's draw" and is not taxable income since the LLC's income is already reported on your personal tax return. However, the transfer itself doesn't trigger a tax event.
S Corp owners must file Form 1120-S, U.S. Income Tax Return for an S Corporation. Both C and S Corps follow the same guidelines for filing taxes with no income. If you had no income, you must file the corporation income tax return, regardless of whether you had expenses or not.
However, when you take an owner's draw, it chips away at the equity your company maintains. A salary, on the other hand, provides a stable, predictable income. Paying yourself a salary also has the benefit of reducing your business's taxable net income.
A shareholder distribution is a way to take funds out of your business without incurring payroll taxes. For a solely owned S Corporation, this is achieved by transferring funds from your business checking account to your personal bank account.
Corporations, S-Corps, and Partnerships may only claim actual expenses for vehicles. Thus, your S-Corp may claim depreciation, fuel expenses, oil expenses, repairs, insurance, and so forth.
The direct answer to whether an S Corp can pay a shareholder's mortgage is no. Personal expenses, including mortgage payments, cannot be directly paid by the corporation without significant tax implications and potential violations of IRS regulations.
Some unique income tax rules apply to S corporations regarding compensation and fringe benefits paid to shareholders who own greater than 2% of the corporation. Under these S corp income tax rules, a greater than 2% shareholder is taxed as a partner in a partnership for fringe benefits received.
Ownership rules for S Corporations
This means no partnerships or corporations can own an S Corporation. There's a maximum of 100 shareholders. If you are the only shareholder, this isn't an issue, but it's good to know if you plan to expand.