[cullenking]

The other two replies are incorrect (I have up until this year run our business as an S-Corp).

With an S-Corp, you pay your owners a reasonable salary. $50-70k is reasonable for our field according to our CPA. Any profits or losses from the business pass through to your personal income tax via a Schedule K1. The profits are taxed like normal income, they are not taxed as capital gains.

The tax savings come from the fact that the distributions you draw from the profits of the company are not subject to FICA (medicare, social security). This saves you upwards of 13%.

If you draw more than your profits for the year (say you run an accrual method of accounting, not cash, so you recognize revenue after services have been fully rendered, rather than when the cash comes in and you can have a large bank balance but no profit for that year), the excess is essentially double taxed with capital gains. A painful mistake, so track your AAA appropriately :)

[atria]

Interesting. When I ran my S Corp, my goal was to avoid estimated tax payments. At the end of the year, the accountant would calculate the required taxes and I would issue a "net zero" check that only paid taxes, or a bonus check with a enormous withholding. The remainder was taken out as a dividend.

Taxes paid via withholding are treated as if they are paid in through the course of the year which avoids estimated tax payment penalties.

[cullenking]

Yeah, I just do the quarterly estimated payments. If your business is constant (not growing) it's easy to handle via extra withholdings. If you are growing, they at least make it easy so that if you pay an estimated tax that matches the prior years tax owed (paid quarterly) you avoid any penalties, even if you have to make a lump payment to settle up the difference when you do your taxes at the end of the year.

We have a pretty sophisticated business intelligence platform written in R that gets us estimated revenues within 10%, so I know how to budget through the year for taxes owed. I just pay my known quarterlies and keep enough in the bank to handle the remainder at year end.

[delinka]

I'm certainly willing to concede that I'm wrong (I'm by no means an expert), but your advice is counter to what I've received from professionals. I'm curious whether you've run into this problem with others in the accounting, law, or tax professions and why the misconception (that I hold) exists.

[cullenking]

The problems I have run into have been acting like I know more than I actually do. Our first accountant assumed I knew everything since I acted like I was making informed decisions, which led to some issues. He also made a few mistakes (not capitalizing on section 179 one year for example).

In regard to your question about why your misconception is common, no idea. Just a quick google shows lots of accurate descriptions of the benefits of an S-Corp. Maybe a misunderstanding with your accountants?

After moving to a larger (and much more expensive) accounting firm, and learning from our previous mistakes, I've had a much more pleasant time dealing with this stuff. It's all arcane and stupid when it comes down to it, but you have to learn it to effectively manage your tax burden. If you don't actively think about it you get absolutely screwed on occasion, as it affects everything about your business. And the mistakes get expensive as your revenue scales up.

This is getting totally tangential, but you can probably hardly imagine all the crazy rules regarding taxation in the case of a sales event. Operating as an S-Corp is fine and dandy, but creates an additional hurdle for getting investment and for sales. S-Corps can only be owned by individuals, so an acquisition or an investment means restructuring, but you are restructuring after a planned purchase, which says certain things about intent which makes the restructuring likely a taxable event in and of itself.

I strongly strongly strongly recommend talking to an experienced business lawyer, and having them recommend an experienced business tax planner. This isn't schemey tax avoidance stuff, this is fundamental planning so you don't get a surprise $200k bill at some point!

[delinka]

A quick Google search gives me this from the first result[1]:

"Then, any remaining profits from the company can be distributed to the owners as dividends, which are taxed at a lower rate than income."

Though it doesn't specify what that rate is. Most of the other results indicate that the additional distributions beyond salary simply avoid self-employment tax. So it would appear that distributions beyond salary incur less tax, but are taxed higher than the current capital gains tax rate. It's also important to note that distributions are taxed - if you leave the money in the company, it's not taxed until it's actually distributed to the owners.

1 - http://www.inc.com/guides/201103/s-corp-vs-llc.html

[cullenking]

Again incorrect, all company profits are taxed regardless of whether you withdraw it in the form of distributions. If you withdraw distributions in excess of your basis (your share of accumulated profits/losses in the company, it can be negative or 0) then yes the distributions you take above your basis are then taxed as capital gains. Don't do that. I strongly advise finding a reliable, recommended professional to talk to about this stuff. We found a fantastic guy through our business lawyer, wish we would have found him earlier.

[delinka]

It boils down to this: don't trust search engine results and search out a competent professional. The problem I see is knowing who the competent professionals are.

[iolothebard]

179 is the best thing in the history of tax law IMO. :-)