S Corps. Single owner. How record salary you pay yourself on 1040. It that earned income.

[dnmalkin]

This is my first year as an S Corp. I noticed that if you get paid profits from K1, when you record this on Schedule E, it comes in as ordinary income. I noticed that this disallows you for the EIC because the income is not earned income.

Here is my question. Let's say I do 60/40 between distributions and owner salary (from 1120s profits). I want to pay my salary as a year end bonus. Assume Profits are $100,000. $60K to distributions and 40K to Owner Salary. Does the K1 show $60K distributions and/or $40K salary? How do I show the $40K salary on my 1040? I think it goes under wages section. I think I send myself a w2. (would I also need to send a copy of the w2 to IRS)

And 1 last question, would I need to file estimated taxes each quarter and settle up at year end tax time?

[Anonymous_]

Yes, you should issue a W-2 to yourself from the S corporation and note that you also need to pay FICA (and withholding if applicable). Also, the W-2 needs to be sent to the IRS (along with the transmittal Form W-3). The withholding for federal income tax on the W-2 is treated as having been withheld equally throughout the tax year.

You should actually consult with a local tax professional for this matter. For one thing, you need to ensure that $40k is a reasonable salary for your particular position and type of business.

Just for your information, the salary the S corporation pays you is deductible by the S corporation; it is deducted on your 1120-S and appears on your W-2 but does not appear on your K-1.

[Opus 17]

As the owner of an S-corp you must always first pay yourself a reasonable (fair market) salary that reflects the work you actually do.  That includes tax withholding, submission of form 941 or 944, state tax withholding and submission of quarterly or annual state tax withholding forms, and issuing a W-2.  There are payroll companies that will do this for a fee if you can't or don't want to take the time to learn to do it yourself.  The payroll expense is a deductible business expense.

Then, if there are additional profits after paying yourself a fair salary, those profits can be distributed as a profits, dividends, or whatever.

In your example, if your business has a "gross" profit of $100,000 and pays a $40,000 salary, then the business will show a profit of $60,000 (because the $40,000 is an additional expense).  You would get a K-1 showing distribution of profits and a W-2 showing $40,000 of wages.

You can't arbitrarily decide the split between profit and salary, it depends on the fair market value of what you do.  Suppose you hired an unrelated person to run your business, so you paid them a salary and only collected the profits yourself.  How much would have to pay in the current business market and based on the skills and knowledge and time involved?  Under-paying S-corp wages is a key audit target area (because under-paying wages means you pay less social security and medicare tax, among other things). 

[dnmalkin]

Ok, so when I am doing my individual 1040, would I take the $40,000 on the W2 and put that in the wage section of 1040 (line 1)?

My assumption is that this would be earned income and therefore would allow me to take the EIC (earned income credit). Is that correct?

[Opus 17]

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@dnmalkin wrote:

Ok, so when I am doing my individual 1040, would I take the $40,000 on the W2 and put that in the wage section of 1040 (line 1)?

My assumption is that this would be earned income and therefore would allow me to take the EIC (earned income credit). Is that correct?

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In general, wages that your S-corp pays you on a W-2 will count as "earned income" and will help to qualify you for EIC.

But, if your numbers are roughly accurate and you will have $40,000 of earned income and $60,000 of "other" (unearned) income, you will be disqualified, since your adjusted gross income will more than the upper threshold.  Remember that EIC is a credit for low income workers, to encourage people to work, and to make up for the fact that social security and medicare are "regressive" taxes (every worker pays social security and medicare even if they have enough deductions and credits to not pay income tax.  EIC started out, at least in theory, as a rebate of social security and medicare tax for the lowest income workers.)  If your total income is more than the upper limit, you don't get EIC because you aren't "lower income" any more.

See table 1 in publication 596.https://www.irs.gov/publications/p596