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 Depreciation No Longer Exists for Small Businesses

With Congress' passage of the Protecting Americans From Tax Hikes Act of 2015 (PATH), Congress did more than just protect Americans from tax hikes...they eliminated depreciation altogether for most small businesses.  

In PATH, Congress extended Section 179 depreciation permanently, which means that from 2015 until infinity, a business can expense 100% of the cost of most new or used assets in the year of purchase, as long as the cost doesn't exceed $500,000 or the total assets purchased don't exceed $2 million.  

This new law achieves what small business owners have been vying after for some time - that cash spent is directly related to a tax deduction.  

Couple this new law with the repair regs, which allow a small business to elect all expenses $2,500 or less are repairs and maintenance, and Congress has effectively eliminated the need for depreciation to extend over a number of years.  

Think about it: if a small business buys a new computer for $1,000, they can expense it.  If they buy a new x-ray machine for $25,000, they can expense it.  The only time a small business will get into a situation of having to depreciate an asset is if it does not qualify for Section 179 or it costs more than $500,000.  

This is a dream come true for small business owners that live by cash flow and want all of their purchases to translate into tax deductions.  

Why a "flat tax" won't work

As we near the 2016 election season, you will undoubtedly hear some candidates tout their desire for a "flat tax" or a "fair tax".  Being in the tax profession, I could not agree more that our current tax system is cumbersome and complicated.  But, getting rid of the IRS and taking the country to a flat/fair tax is not as easy as it sounds.  Following are a few reasons why.  

Income

In most of the examples of the flat tax I have seen, a flat 15% is deducted from someone's paycheck, instead of Federal withholding, FICA, Medicare, etc.  This sounds great, but what about people that don't get a real paycheck?  What if all my income is derived from investments or partnerships / S-corps?  Are interest and dividends considered earned income for the flat tax?  Is the gross income from my partnership subject to the flat tax, even though I might have distributed more or less of that to myself during the year?  In the end, someone will have to determine what "income" is subject to the flat tax, which will ultimately lead to the same loopholes and treatments that we have in place today.  

Incentives

Our current tax code offers several incentives to businesses for purchasing capital assets and maintaining employees.  For example, Section 179 and bonus depreciation allow a taxpayer to expense 50% or 100% of a qualified asset in the year it is purchased.  This gives the business an immediate tax benefit for purchasing new equipment.  If that goes away, businesses are likely to ride out their equipment longer, putting a strain on parts of the economy where the equipment is manufactured.  If new equipment is not purchased, the manufacturing companies won't need to keep as many plants open, meaning people will ultimately lose their jobs.  

Pressure

Another reason why we won't be able to easily walk away from our current tax structure is pressure - pressure to fund Social Security, Medicare, and the Affordable Care Act.  If all contributions to Social Security that come from your paycheck and self-employment taxes ceased today, then Social Security benefits would probably run out next week.  If revenue is not received from your paycheck and the net investment income tax to fund Medicare, then millions of people would go without health coverage ... next week.  And, a function of the Affordable Care Act is for people that receive subsidies to pay them back if their income exceeds what they estimated when they applied for coverage.  If those don't get paid back, then the whole Affordable Care Act will fail ... next week.  I'm not saying I agree with all of these policies, but I am saying that the pressure to keep them going is stronger than the pressure to move away from our current tax system.  

In closing, a flat tax sounds great on the surface.  But, it can't apply universally to every situation, and it might end up doing more harm than good.  Remember, we already have a flat tax built into our current tax system - it's called the Alternative Minimum Tax, which requires people in a certain income level to pay at least 26% income tax.